From BlackRock: Matt and Sara sat down to chat about how factor-based insights can help build better fixed income portfolios in a cost effective and transparent way.

The first months of 2017 have surprised us several times already—the Dow reached an all-time high of 20,619 on February 16, 10-year U.S. Treasury yields have stayed above 2.4% for the first time since mid-2015, and Adele scooped Beyoncé at the Grammys (sources: Bloomberg and The Recording Academy). But some things haven’t changed—investors are still challenged by the seemingly never-ending search for yield in an environment of potential rising interest rates. Even after the backup in rates in the fourth quarter, Federal Reserve Chair Janet Yellen’s testimony last month suggests that further rate hikes are likely in 2017. So what is an investor to do?

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To answer that question, I caught up with my colleague Sara Shores, Global Head of Smart Beta, to talk about how factor-based investing and smart beta in fixed income can help investors navigate the current market environment.

Matt: We’ve been reminding investors that regardless of the rate environment, there are reasons to hold on to bonds. What does factor investing tell us about the attractiveness of bonds in the current climate?

Sara: Diversification is the first rule of factor investing, so I wholeheartedly agree investors should not dismiss fixed income offhand. We want to build portfolios that are deliberately diversified across fundamental drivers that impact all asset classes. While equity market movements are driven largely by the strength of economic growth, fixed income markets hinge on changes in interest rates and inflation. Regardless of how buoyant investors are today, we know we must expect the unexpected and be prepared for the next market shock. In other words, bonds are a source of diversification from the equity risk that dominates most investors’ portfolios. In fact, the recent backup in yields makes bonds an asset class worth considering—both because the yield has been higher, and because the majority of the interest rate movement expected for 2017 may have already been priced into the market.

Matt: Interest rate movements are obviously an important driver for fixed income portfolios. Are there other fixed income factors that investors should think about in the current environment?

Sara: In the same way that diversification is important across asset classes, diversification is important within fixed income portfolios. One way to help protect from unexpected interest rate moves is to diversify the interest rate exposure that is at the center of any fixed income portfolio. An easy way to get a better balance is through increased allocation to credit. Credit provides the potential for both diversification and incremental returns: While rate-driven government bonds have been rewarded during flight to quality periods, credit has been rewarded in times of strong economic growth. In fact, the long run correlation between interest rates and credit is decidedly negative at approximately -0.34 (source: Bloomberg, data from July 1991 to October 2016). Also, credit investments, like investment grade and high yield corporate bonds, tend to have higher yields than government bonds. Combining interest rate risk and credit risk together in a fixed income portfolio, e.g. iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR), has the potential to generate income while potentially decreasing interest rate risk. See the accompanying chart.

Matt: That’s a good way to think about core fixed income, and it could help investors to potentially reduce risk without having to give up on the potential for yield. I hear you talking about interest rates and credit as factors in a fixed income portfolio. Is this similar to how we talk about factors in equity markets?

Sara: Interest rates and credit are what we call macro factors. They drive the overall level of returns in markets, and drive differences in return between asset classes. In equity markets, we mainly talk about style factors; these drive differences in return between individual securities.

Matt: So how do you translate equity factors like value and quality to fixed income smart beta?

Sara: The same economic rationale that drives style factors in equities are present in other asset classes. Value is the classic example: Bonds that are inexpensive relative to fundamentals tend to outperform their expensive peers (source: Ang, Andrew. Asset Management: A Systematic Approach to Factor Investing. Oxford University Press. 2014.). One thing that’s markedly different about bond markets, however, is the inherent asymmetry of potential returns: The best a bond can do is pull to par, but the worst it can do is default—taking your capital investment with it. That means your downside risk is disproportionately larger than your upside opportunity, and that makes avoiding defaults the most important aspect of security selection. When we screen for strong balance sheets in equities, we call it quality, and the quest for strong balance sheets is even more important in fixed income. Quality is an excellent complement to value; the combination of the two helps investors avoid common investing traps. We want bonds that are inexpensive, but not cheap for a reason. We want strong balance sheets, but not at any price. Screening for both quality and value means we invest in securities that are both high quality and fairly valued.

Matt: Thank you Sara. These factor insights are the building blocks that our research team uses to create particular outcomes for portfolios. For example, in high yield strategies, we may want to screen for value and quality to potentially lower downside risk without giving up potential yield. In investment grade strategies, many investors are more interested in seeking higher yields without having to take on additional risk. And that’s the happy marriage of smart beta and fixed income: using factor based insights to potentially create better outcomes in fixed income portfolios in a cost effective and transparent way.

The iShares Edge U.S. Fixed Income Balanced Risk ETF (BATS:FIBR) was unchanged in premarket trading Thursday. Year-to-date, FIBR has gained 0.36%, versus a 7.27% rise in the benchmark S&P 500 index during the same period.

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This article is brought to you courtesy of BlackRock.

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