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Quantitative Strategies: Quantitative Strategies THE JOURNAL MANAGEMENT PORTFOLIO OF www.iijournals.com jpm.iijournals.com QUANTITATIVE STRATEGIES: STRATEGIES: QUANTITATIVE QUANTITATIVE STRATEGIES: THIRD EDITION 2018 FACTOR INVESTING FACTOR INVESTING FACTOR Style Investing in Fixed Income | THIRD EDITION THIRD JORDAN BROOKS, DIOGO PALHARES, AND SCOTT RICHARDSON | MARCH 2018 MARCH 131981_wrmw.indd 1 3/22/18 8:55 AM risk (e.g., credit risk premium, equity risk premium, or classes (stocks, bonds, currencies, and commodities) over term premium), nor do they give exposure to equity the periods considered. style portfolio returns (e.g., factors such as size, value, In this article, we apply style premiums to country momentum, or quality within equity markets). Third, and maturity selection across global government bond we see very little sensitivity of FI style portfolio returns markets and to individual issuer selection across U.S. Style Investing in Fixed Income to various macroeconomic state variables that are typi- corporate credits. The results are closely related to two cally a concern for investors (e.g., shocks to inflation, papers—by Brooks and Moskowitz [2017] and Israel, shocks to economic growth, shocks to real yields, shocks Palhares, and Richardson [2018]—which provide ORDAN ROOKS IOGO ALHARES AND COTT ICHARDSON J B , D P , S R to liquidity, and shocks to volatility) and meaningfully many extensions and further detail on style investing less sensitivity to these variables than the underlying in government bond markets and corporate credit mar- asset classes themselves. These results are important kets, respectively. The choice of measures we consider because the excess returns of active FI managers as a here mirror those in the original work of Brooks and group have substantial exposures to traditional market Moskowitz [2017] and Israel, Palhares, and Richardson risk premiums, especially the credit risk premium (see, [2018]. Common to our choices for both government e.g., Mattu et al. [2016]; AQR Capital Management and corporate bonds is the desire to use simple and easily JORDAN BROOKS tyle premiums, or factor-based, We find that, despite the slower adoption [2017]; Baz et al. [2017]). replicable measures. is a managing director at investing has been applied in equity of style investing in FI, well-established style Overall, our empirical analysis suggests a pow- Our style measures reflect the general intuition AQR Capital Management markets for over 20 years and has premiums identified in other asset classes— erful role for style-based investing in FI. Although our underlying the risk-based, mispricing and/or market- LLC in Greenwich, CT. [email protected] become increasingly popular, mainly value, momentum, carry, and defensive— analysis focuses on long–short academic style port- friction-based explanations that are typically provided Sin long-only applications (i.e., smart beta). could have enhanced returns in various FI folios, we discuss potential implementation options. as support for style-based investing (e.g., Asness et al. DIOGO PALHARES Style investing has also been extended to markets over the past two decades. We dem- For fuller details of implementation challenges and [2015]). However, we need to tailor the respective is a vice president at AQR long–short, market-neutral applications in onstrate FI style investing efficacy with optimized long-only portfolios in corporate bonds, measures to reflect the returns and risks that matter for Capital Management LLC several asset classes, including bonds, cur- market-neutral country and maturity allo- please refer to Israel, Palhares, and Richardson [2018]. government and corporate bonds. in Greenwich, CT. rencies, and commodities (Asness et al. cation strategies in global government bond Common to both long–short and long-only imple- Value is the tendency for relatively cheap assets to [email protected] [2015]). Still, style investing appears to have markets and with individual issuer allocation mentations of style-based investing in FI is the low outperform relatively expensive assets. Thus, for value SCOTT RICHARDSON a smaller footprint in fixed income (FI) than strategies in U.S. corporate bond markets correlation between styles and the strategic style portfolios we need a credible measure of fundamental is a principal at AQR in equities, both in the academic literature (our universe includes both investment-grade diversification benefit to an end investor. We find value to compare against market prices. We measure Capital Management LLC and in investment practice (for reference, a and speculative-grade, or high-yield, bonds). that both long-only style-tilted portfolios and long– market prices as yields in the case of government bonds and a professor at London few of the limited number of papers include Using large samples of government and cor- short style portfolios have important uses, and the and as credit spreads in the case of corporate bonds. Business School in London, U.K. Brooks and Moskowitz [2017]; Houweling porate bonds that span over 20 years of data, right allocation to the two approaches depends on For government bonds, we use real yield as our mea- [email protected] and van Zundert [2017], and Israel, Palhares, we find positive Sharpe ratios for all styles. investor constraints. sure of value. Specifically, we compare nominal yields and Richardson [2018]). For example, an equal risk allocation across against maturity-matched inflation expectations. We use FI markets are enormous. As of the four well-known style premiums gener- MEASURING STYLES IN FI survey-based forecasts of inflation from Consensus Eco- December 31, 2017, the Bloomberg Barclays ates a gross Sharpe ratio of 0.98 (2.52) for a nomics. Relative to their peers, government bonds with Global Aggregate Index contained invest- portfolio of government (corporate) bonds. Style Definitions and Measures higher (lower) real yields are cheap (expensive). For ment-grade-rated debt amounting to about We further examine the diversifying corporate bonds, we compare credit-option-adjusted $45 trillion. Inside this broad index are a potential of style-based FI portfolios for There is an extensive literature in financial eco- spreads against two fundamental anchors designed to variety of bonds issued by governments, gov- investors. First, we see strong evidence of nomics documenting robust evidence of a positive rela- capture the risk that the company may migrate to a ernment-related entities, and corporations, as low correlation across style portfolios both tion between value, momentum, carry, and defensive/ poorer credit quality. Our first fundamental anchor is well as asset-backed securities. Our purpose is within and across government and corporate quality styles and future asset returns across multiple asset a structural model that measures the bond’s distance to to describe a general framework to measure bonds. This is consistent with past research classes (see, e.g., Koijen et al. [2018] for carry; Frazzini default, reflecting the number of standard deviations well-known styles for both government and documenting the diversification benefit of and Pedersen [2014] for quality; Asness, Moskowitz, and the asset value is away from the default threshold (for corporate bonds. These are large components investing across styles and across asset classes Pedersen [2013] for momentum and value; and Asness full details, please refer to Correia, Richardson, and of the global aggregate index (approximately (see e.g., Asness, Moskowitz, and Pedersen et al. [2015] for a combination of all four characteristics). Tuna [2012]). Our second fundamental anchor is an 55% for government bonds and 20% for cor- [2013] and Asness et al. [2015]). Second, With the exception of carry, this literature first focused empirical model based on a regression of the spread on porate bonds), and they have not been subject we see strong evidence that FI style port- on stock selection strategies and eventually found that duration, rating, and return volatility (for full details, to much empirical analysis of cross-sectional folios can be built in such a way that they these style premiums travel well to other domains and please refer to Israel, Palhares, and Richardson [2018]). determinants of excess returns. do not give exposure to traditional market have generated long-run outperformance in several asset In both cases, a corporate bond is deemed to be cheap QUANTITATIVE SPECIAL ISSUE 2018 THE JOURNAL OF PORTFOLIO MANAGEMENT STYLE INVESTING IN FIXED INCOME QUANTITATIVE SPECIAL ISSUE 2018 JPM-Brooks.indd131981_wrmw.indd 127 2 10/03/183/22/18 8:554:39 AMpm JPM-Brooks.indd 128 10/03/18 4:39 pm risk (e.g., credit risk premium, equity risk premium, or classes (stocks, bonds, currencies, and commodities) over term premium), nor do they give exposure to equity the periods considered. style portfolio returns (e.g., factors such as size, value, In this article, we apply style premiums to country momentum, or quality within equity markets). Third, and maturity selection across global government bond we see very little sensitivity of FI style portfolio returns markets and to individual issuer selection across U.S. Style Investing in Fixed Income to various macroeconomic state variables that are typi- corporate credits. The results are closely related to two cally a concern for investors (e.g., shocks to inflation, papers—by Brooks and Moskowitz [2017] and Israel, shocks to economic growth, shocks to real yields, shocks Palhares, and Richardson [2018]—which provide ORDAN ROOKS IOGO ALHARES AND COTT ICHARDSON J B , D P , S R to liquidity, and shocks to volatility) and meaningfully many extensions and further detail on style investing less sensitivity to these variables than the underlying in government bond markets and corporate credit mar- asset classes themselves. These results are important kets, respectively. The choice of measures we consider because the excess returns of active FI managers as a here mirror those in the original work of Brooks and group have substantial exposures to traditional market Moskowitz [2017] and Israel, Palhares, and Richardson risk premiums, especially the credit risk premium (see, [2018].
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