Monday, February 28, 2022

Fixed Income Factor Investing - Part III - The Factor Model

 


Fixed income factor investing has been extensively tested, so investor have a good idea of the key risk relationships across, value, carry, volatility, momentum, and size. The risk factors measured are statistically significant, but the amount of variation that is left unexplained is high and there is room for skill to improve long/short investing.  


Different risk factors variations such as value, momentum, volatility, quality, and carry all show significant return to risk and positive Sharpe ratios for buying the best quartiles across several studies covering different time periods and factor representations. Long/short portfolios show strongly positive Sharpe ratios often above 1.

The risk factors are sensitive to increasing and decreasing macro variables such as growth, inflation, real rates, volatility and illiquidity so that adding macro tilts will improve return potential. While trading in credit is more difficult than equities, the framework for measuring risk and return opportunities provides value for investors.      

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