Style Investing in Fixed Income
- Jordan Brooks,Diogo Palhares, Scott Richardson
- Journal of Portfolio Management, Special Issue 2018
- A version of this paper can be found here
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What are the Research Questions?
The paper investigates this issue by answering the following research questions:
- Can common robust risk premia (value, momentum, carry and defensive) enhance returns in Fixed Income investing?
- Do style-based Fixed Income portfolios present diversifying potential?
- Is a long/short implementation necessary to reap these benefits?
What are the Academic Insights?By applying style premiums to country and maturity selection across global government bond markets and to individual issuer selection across U.S. corporate credits, the authors find the following:
- YES- The analysis performed (over the 1996-2017 sample) shows that all style premia present positive Sharpe ratios for government and corporate bonds. An equal-weight combination of the four styles improves the results even further*
- YES- Not only correlations among the four styles show that the combination of all of them is a superior portfolio implementation. The authors analyze the correlations of each FI style to three market premiums (credit, ERP and bond term premium) and to four equity styles (value, momentum, size, and quality). The results show that the combination of the four fixed income styles have no exposure to market risk premiums or equity styles**.
- NO- The analysis shows that long only tilts are value-additive. However, the authors note that a long-short implementation provides a better diversification.
Why does it matter?Despite the size of the fixed income market (as of December 2017, the Bloomberg Barclays Global Aggregate Index contains IG debt amounting to $45 trillion), there is not much empirical evidence on the cross-sectional determinants of excess returns. This study contributes to this evidence and shows that traditional risk premia investigated in other asset classes (value, momentum, carry and defensive) could enhance returns in fixed income investments. For further academic insights on this topic, check out the following two studies: Israel et al. (2018) Brooks and Moskowitz (2017) *Results in this paper don’t account for transaction costs. The authors acknowledge this fact and direct the readers to the Israel et al. (2018) paper which shows how results are robust to transaction costs. **Results on diversification are related to a long/short implementation of factors
The Most Important Chart from the Paper
Style investing has become part of the investing nomenclature for equity markets. To date, despite the massive size of fixed-income markets, little research has examined the efficacy of style-based investing in fixed income. In this article, the authors summarize a common style-based framework for capturing excess returns for both government and corporate bonds. Importantly, from an investor perspective, these style-based excess returns are highly diversifying with respect to the classic risk premiums in fixed-income markets (i.e., term premium and credit risk premium) and exhibit low macroeconomic sensitivities.