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Risk Off, Yields Move Lower

Credit Spread and Low Volatility Factors

Is There Merit in Blending Factors in Smart Beta Strategies?

Factor-Based Investing in US IG Corporate Bonds: Volatility and Credit Spread

Looking Beyond the Short Term

Risk Off, Yields Move Lower

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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Global yields are lower year-to-date in all developed countries except Hong Kong, as measured by the S&P Global Developed Sovereign Bond Index.

Weak economic growth, low inflation, and concern over the situation in the Middle East have led many to invest in safer assets.

The U.S. market took note of the slowing growth, both domestically and internationally, as the S&P/BGCantor Current 10-Year U.S. Treasury Index’s yield-to-worst moved 13 bps lower between the week of Jan. 28, 2016, and Feb. 4, 2016.

Japan’s policy makers switched to negative interest rates in an attempt to keep the economy from going deeper into the malaise that has weighed down its economy for the last two decades.

The European Central Bank is in a sub-zero interest rate environment as well.

The Bank of England board members voted unanimously to hold rates at 0.5%.

The Swedish Riksbank will meet Feb. 11, 2016, possibly to announce even lower interest rates, after adopting negative interest rates a year ago.

Oil prices, as measured by WTI crude oil futures, have moved down 18% since the beginning of the year to USD 31, as of Feb. 4, 2016.

Exhibit 1: Countries of the S&P Global Developed Sovereign Bond Index
Countries of the S&P Global Developed Sovereign Bond Index

 

 

 

 

 

 

Source: S&P Dow Jones Indices LLC.  Data as of Feb. 4, 2016.  Chart is provided for Illustrative purposes.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Credit Spread and Low Volatility Factors

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Hong Xie

Senior Director, Global Research & Design

S&P Dow Jones Indices

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Factor Definition
The fixed income investment community has long used volatility in analyzing bond valuations and identifying investment opportunities.  We have defined volatility as the standard deviation of bond yield changes for the trailing six-month period.  All else being equal, the more volatile the bond yield is, the higher the yield needs to be in order to compensate for the volatility risk.

For the credit spread factor, we consider the option adjusted spread (OAS), which represents the yield compensation for bearing credit risk, as well as other risks associated with credit.  OAS is a common measure of valuation for corporate bonds.

Factor Identification
To identify the factors that could enhance security selection, we computed the performance statistics of the quintile portfolios ranked by each factor and demonstrated the strong relationship of factor exposure, portfolio return, and return volatility.

The underlying universe for our study was the S&P U.S. Issued Investment Grade Corporate Bond Index (U.S. issuers).  The index seeks to measure the performance of investment-grade corporate bonds issued by U.S.-domiciled corporations denominated in U.S. dollars.  Based on the availability of the constituent data and the yield curve, the period covered in the study was from June 30, 2006, through Aug. 31, 2015.  We derived an investable sub-universe (details in next blog) based on the broad universe and constructed quintile portfolios of the investable sub-universe.

To form the quintile portfolios, we first ranked bonds within the investable sub-universe by each factor (credit spread and low volatility) and divided the universe into five groups, with higher values ranking higher (Quintile 1) for credit spread and lower values ranking higher (Quintile 1) for low volatility.  It should be noted that these two single-factor portfolios did not control for either duration or credit rating.  Exhibit 1 shows the performance statistics of ranked quintile portfolios by single factors.

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Exhibit 1 confirms a positive relationship between credit spread, portfolio return, and return volatility; i.e., the wider the credit spread is, the higher the return and return volatility are (Quintile 1).  Contrary to the credit spread factor, we observed a non-linear relationship between risk and return for the low volatility factor.  The Quintile 1 portfolio, containing the least volatile bonds, had the lowest return and the highest level of realized portfolio volatility.

Exhibit 1 also includes performance statistics for the quintile portfolios formed by ranking the low volatility factor within each duration and rating grouping.  These modified quintile portfolios displayed a generally positive relationship between the low volatility factor, return, and return volatility, as expected.

This demonstrates that applying the low volatility factor without taking duration and quality into consideration is not consistent in explaining portfolio return and risk.  This is because simply ranking bonds by yield volatility across the universe can potentially result in highly concentrated portfolios in duration or quality, which in turn can cause greater portfolio volatility.  This can be particularly exacerbated when long-duration bonds exhibit lower yield volatility than short-duration bonds when the market is quiet.

These findings confirm that credit spread and low volatility factors can effectively explain portfolio return and volatility and present the necessity of applying factors while taking duration and quality into consideration.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Is There Merit in Blending Factors in Smart Beta Strategies?

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Priscilla Luk

Managing Director, Global Research & Design, APAC

S&P Dow Jones Indices

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Despite the fact that many single-factor strategies have empirically delivered positive excess returns in the long run, they have suffered periods of substantial underperformance under certain market conditions due to their cyclicality.  Blending a number of desired factors with low correlations is a potential way to attain more balanced and diversified portfolios.  The obvious questions that arise are: Are they likely to achieve better performance?  How do they behave in different financial environments?

Our stylized portfolios that blend six factors (volatility, value, quality, size, momentum, and dividend yield) with four different strategies (marginal risk contribution, minimum variance, Sharpe-ratio weighted, and equity weighted) demonstrated higher risk-adjusted returns than the S&P 500®, with a lower tracking error than most single-factor strategies (see Exhibit 1).

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Over the entire period, marginal risk contribution and equal-weighted strategies exhibited less cyclicality than other multi-factor and most single-factor strategies.  They achieved more consistent and higher excess return than other strategies across various market cycle phases.  On average, they produced higher information ratios and a higher incidence of outperformance during recovery and bearish periods.

The minimum-variance strategy had a significantly lower information ratio and a lower incidence of outperformance in bullish and recovery markets, similar to, but less defensive than, the single low-volatility strategy.  The Sharpe-ratio-weighted strategy performed well in bear markets, but it significantly lagged the S&P 500 in recovery periods.  This suggests that using recent momentum to tilt factor exposures did not improve the risk-adjusted return of the multi-factor portfolio, even though it had a lower drawdown as a result of the strategy moving into cash during the global financial crisis.

For more information on our research on multi-factor smart beta strategies, please click here, where you will also find details about:

  • What is driving risk/return of various smart beta strategies, and
  • How each of the smart beta strategies have performed in different macroeconomic and market environments.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Factor-Based Investing in US IG Corporate Bonds: Volatility and Credit Spread

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Hong Xie

Senior Director, Global Research & Design

S&P Dow Jones Indices

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Factor-based investing in equities is a well-established concept supported by over four decades of research. However, factor-based investing in fixed income remains in its nascent stages. Our analysis has found that factor-based fixed income strategies implemented in a rules-based, transparent index can represent an alternative tool for fixed income portfolio construction. In the next few blogs, we will detail our approach to and back-tested results of employing credit spread (value) and volatility as factors in order to systematically construct a portfolio of U.S. investment-grade corporate bonds.

Investment Philosophy
In practice, an active portfolio manager for a corporate bond mandate mostly focuses on credit returns, specializing in expressing views on the direction of credit spreads and security selection. We propose a two-factor model to seek to collect an active return from security selection, identifying relative value opportunity in credit returns while keeping portfolio duration and credit duration natural to the underlying universe.

Two Factors: Volatility and Credit Spread
To achieve better security selection, we chose two factors that empirically have demonstrated a strong relationship between factor exposure and performance statistics and that have long been incorporated in investment analysis by corporate bond portfolio managers. Our selection of factors was by no means exhaustive.

The fixed income investment community has long used volatility in analyzing bond valuations and identifying investment opportunities. We have defined volatility as the standard deviation of bond yield changes for the trailing six-month period. All else being equal, the more volatile the bond yield is, the higher the yield needs to be in order to compensate for the volatility risk.

For the credit spread factor, we consider the option-adjusted spread (OAS), which represents the yield compensation for bearing credit risk and other risks associated with credit. OAS is a common measure of valuation for corporate bonds.

Back-Testing Total Return

Exhibit 1 shows the cumulative total return for our two-factor model versus the broad market. In the next post, we will demonstrate how we identify these two factors.

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The posts on this blog are opinions, not advice. Please read our Disclaimers.

Looking Beyond the Short Term

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Kelly Tang

Director

Global Research & Design

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This is the first in a series of blog posts relating to the launch of the S&P Long-Term Value Creation (LTVC) Global Index.

The debate continues on the detrimental impact of the short-term mindset of public companies.  Short-termism (a.k.a. quarterly capitalism) is defined as companies’ fixation on managing for the short term, with decisions driven by the need to meet quarterly earnings at the cost of long-term investment.  Short-termism is a problem because it has the potential to undermine future economic growth.  The lack of long-term investment will ultimately lead to slowing GDP, higher unemployment levels, and lower future investment returns for savers—all combined, these effects hurt everyone.  There’s a consensus that the main source of the problem is the tremendous pressure that public companies face from financial markets to maximize short-term results time and time again.  Back in 2013, McKinsey and the Canada Pension Plan Investment Board (CPPIB) conducted a McKinsey Quarterly global survey of more than 1,000 board members and C-suite executives to gauge their long-term approach in managing their companies.

  • 63% of respondents said the pressure to generate strong short-term results had increased over the previous five years.
  • 79% felt pressured to demonstrate strong financial performance over a period of just two years or less.
  • 44% said they use a time horizon of less than three years in setting strategy.
  • 73% said they should use a time horizon of more than three years.
  • 86% declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation.
  • 46% said that the pressure to deliver strong short-term financial performance stemmed from their boards; while the board members expressed that they were just channeling the short-term pressures felt from institutional investors.

The results were startling and bring to light how deeply the short-term mindset has permeated corporate culture.  However, the good news is that a coalition of institutional investors is realizing that telling company management to focus on the long term, and thereby placing the entire onus on them, is both unrealistic and ineffectual.  They feel that the only way to shift the mindset to long-term value creation is by calling upon other asset owners who control the assets that companies need to change their current approach.  Asset owners are the key constituents to effect real change and their buy-in to long-term thinking will facilitate the process for other players such as asset managers, corporate boards, and company executives to move away from short-termism.

Our next blog will discuss how CPPIB and S&P Dow Jones Indices worked together to design an index that seeks to address the short-termism undermining global economies.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.