Asset managers have found fixed income factors — systematic sources of bond returns — to be fertile ground for product development.
But new research from Dimensional Fund Advisors, a pioneer in factor-based funds, finds that investors only need two factors — forward rates and a bond issuer’s stock returns — to evaluate fixed income investments.
Almost every other variable, including bond momentum and leverage, is irrelevant, according to Dimensional.
“There are several recent papers that propose alternative variables to explain differences in expected returns across bonds, and use them in implementation,” Savina Rizova, Dimensional’s head of research and one of the paper’s authors, said in an interview with Institutional Investor. “But it’s important not to look at these variables in isolation, but within the context of what we already have, which is forward rates.”
A forward rate is the combined yield and expected capital appreciation of a bond based on current market prices. According to Rizova, forward rates are “well documented as a useful metric for targeting bonds with higher expected returns.” For example, University of Chicago Professor Eugene Fama, a Nobel Laureate who is a director and consultant at Dimensional, did original research on forward rates in the 1970s and 1980s.
[II Deep Dive: Dimensional Makes a Change to Its Investment Process]
Dimensional’s new study, entitled “The Cross Section of Corporate Bond Returns,” confirmed the value of the forward rate. It also found that the default-adjusted credit spread, a popular assessment of value calculating a bond’s credit spread relative to the issuer’s chances of defaulting, does not add any signal above the forward rate.
The quantitative asset manager did find that the recent performance of a bond issuer’s stock contains information beyond what is found in the forward rate. If a company’s stock underperforms the overall market in one month, Dimensional found that the issuer’s bonds tend to underperform in the following month. Although the finding itself isn’t new, Dimensional was able to determine how long the information in the metric lasts, which is a much shorter time period than the signal in the forward rate.
“While short-term equity returns provide insight into expected bond returns, our research shows this insight to be somewhat ephemeral — its short term nature means using it in isolation to drive trading decisions could lead to high, and potentially costly, turnover for investors,” the firm said in a blog post on Wednesday.
Dimensional’s study examined the performance of more than 7,000 U.S. dollar-denominated investment-grade and high-yield corporate bonds from January 2000 to December 2018. The study’s four authors tested 14 variables to assess whether they contained information about future bond returns. Other variables studied included short-term credit premium, credit momentum, market capitalization, total public debt outstanding, book-to-market, profitability, distance to default, short-term equity return, and equity momentum.
“We are experiencing a fundamental shift to systematic investing,” Rizova said. “Systematic investing typically implies using quantitative variables — sources of information — to target higher expected returns whether in equities or fixed income.” The rise in popularity of systematic fixed income investing has spurred a similar increase in research of different variables, Rizova said.
“With more interest in that type of investing, which is more transparent, more reliable, and easy to monitor, there has been more effort to identify additional sources of systematic information,” she said. “Some variables in our study do not appear to contain any reliable information, so if you are pursuing them to get higher expected returns by emphasizing bonds with these characteristics, it might be futile.”
