November 20, 2014 - Bonds
Do factor models predict returns for corporate bonds as they do for stocks? In their October 2014 paper entitled “Factor Investing in the Corporate Bond Market”, Patrick Houweling and Jeroen van Zundert develop and test a four-factor (size, low-risk, value and momentum) model of future corporate bond returns. Each month for investment grade and high yield bond market segments separately, they construct an equally-weighted long-only portfolio consisting of the 10% of bonds with the highest exposure to each factor. They hold portfolios for 12 months, resulting in 12 overlapping portfolios for each segment and factor. Specifically, the factor portfolios are:
- Size – the 10% of bonds with the smallest company index weights, calculated as the sum of market value weights of all company bonds in the index that month.
- Low-risk – a combination of rating and maturity. For investment grade, the portfolio holds the 10% of bonds rated AAA to A- and having the shortest maturities. For high yield, the portfolio holds the 10% of bonds rated BB+ to B- and having the shortest maturities. On average, the maturity threshold is 2.8 (3.7) years for investment grade (high yield).
- Value – the 10% of bonds with the largest percentage gaps between actual credit spread and credit spread indicated by monthly regressions of credit spread on rating.
- Momentum – the 10% of bonds with the highest return relative to duration-matched U.S. Treasuries from six months ago to one month ago (with a skip-month to avoid reversal).
They evaluate factor portfolio performance based on excess return of constituent corporate bonds versus duration-matched U.S. Treasuries (thereby focusing on the default premium component of corporate bond returns). To estimate trading frictions, they model bid-ask spreads based on maturity and rating (the longer maturity or the lower the rating, the larger the estimated trading friction). Portfolio-level trading frictions are sums of frictions for all bonds traded. Using monthly data for all bonds in the Barclays U.S. Corporate Investment Grade index and the Barclays U.S. Corporate High Yield index during January 1994 through December 2013 (about 800,000 investment grade and 300,000 high yield bond-month observations), they find that: Keep Reading