![]() In contrast, information in forward rates is relatively long-lived (see Exhibit 3). This time decay, or rate of decline (in information) over time, has direct implications: Implementing strategies based on short-term equity returns might require high levels of excessive trading, thus increasing trading costs. While short-term equity returns are positively related to subsequent bond returns even after controlling for forward rates, the information contained in short-term equity returns tends to decay quickly-typically within a few months (see Exhibit 2). Additionally, short-term equity returns showed little correlation with forward rates. ![]() In other words, recent performance of the issuer’s stock contains information about future performance of the issuer’s bonds, and this information is not subsumed by forward rates. If an issuer’s stock underperformed the market in a given month, its bonds tended to underperform in the subsequent month. In contrast to the numerous other variables examined, we found recent performance of the issuer’s stock provides additional information about the cross-section of expected corporate bond returns. Using both portfolio and statistical, or regression-based approaches, we tested many variables to determine what information, if any, they provide about cross-sectional differences in expected corporate bond returns. To answer this question, we undertook a comprehensive analysis of global bonds. ![]() One could ask: Does the variable in question provide new information about expected bond returns beyond what is already known from forward rates? One way to gain clarity is to consider what new insights or information an alternative variable contributes. Given the large number of proposed factors, investors may be left wondering which ones to pursue and how to best implement a systematic approach to fixed income investing. These strategies show that you can beat the market without trying to identify mispriced bonds or time interest rate changes.Īs is the case with equity factor investing, investors need to look deeper when evaluating fixed income solution-based factors, such as bond and issuer characteristics. 1 The first strategies that systematically exploited the link between forward rates and expected term and credit premiums-the expected return differences between risk-free bonds of different maturity, and corporate and risk-free bonds with the same maturity, respectively-were launched in the 1980s and now have almost 40 years of live performance. This is despite academic research that dates back to Nobel laureate Eugene Fama’s work in the 1970s finding that forward rates, as future expected bond yields, contain useful assessments of differences in expected returns among bonds not held to maturity. While factor-based approaches (those targeting historical drivers or sources of return) have become more common in equity portfolios, systematic approaches in fixed income have faced slower adoption. Either settle for low expectations in terms of what you may earn on a bond, or try to reinstate yesterday’s fixed income returns by reaching for yield earned through additional risk.īut what if there’s a third way to structure bond strategies? One that acknowledges interest rate levels yet realizes they are only part of the fixed income story? And one that harnesses what’s best about systematic approaches while relying on well-established inputs and daily flexibility to manage risks and increase expected returns? Our research suggests that such systematic approaches may well be the future of bond investing. A bond investor’s options today may seem like having to choose between a rock and a hard place.
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