Systematic, rules-based investing has come to dominate equity funds, but despite record flows into fixed-income ETFs over the past year, many advisors still think of bonds as an area where active management makes the most sense. Markets aren’t as liquid, price discovery is an issue and given the roll-off of government Treasuries back into the marketplace following years of buying to stimulate the economy, fixed income is a tough place to take a “buy the index” approach—or so the thinking goes.
The search is on among investment managers and academics to find the “factors” that could be applicable to fixed income securities for a better “rules-based”—cheaper, more transparent—approach.
DFA recently published a far-ranging report, The Cross-Section of Corporate Bond Returns, that confirms the primary usefulness of the metric they use for building bond portfolios—the forward rate, or the expected future rate of a bond investment.
They looked at 7,000 US corporate bonds over 20 years, including both investment-grade and junk bonds all the way down to a “B” credit rating. The bonds were sliced and diced and filtered through 14 metrics, including default-adjusted credit spreads, short-term returns, pricing momentum, as well as issuer metrics like total debt, book-to-market, leverage—to see which reliably pointed toward higher future returns. Only forward rates seemed to be the most reliable indicator. “Many of the metrics that have been cited as predictive of expected bond returns aren’t telling us much new.”
“In a portfolio of corporate bonds, those with the highest forward rates significantly outperformed a portfolio of those with the lowest forward rates to the tune of 3.4% per year from 2000 to 2018,” according to a DFA spokesperson.
The research found only one other metric that pointed to higher future returns for bonds: the recent short-term performance of the issuers’ stock: A one-month record of underperformance of a stock tends to be followed by a one-month underperformance of the bonds, but the researchers caution against using the metric as a trading decision in isolation.
“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,” said Savina Rizova, head of research at Dimensional and co-author of the paper.