Factor investing has grown in popularity over the last few decades, especially with respect to equity markets. After extending Fama-French factors to corporate bond markets, recent research has more often concentrated on the government bond space and revealed that there is indeed clear empirical evidence for the existence of significant government bond factors. Voices that state the opposite refer to outdated data samples. Documenting rather homogeneous empirical evidence, our recent publication underlines the attractiveness of more sophisticated investment approaches – which are well established in equity and even corporate bond markets – to government bonds.
Our article focuses on the five best documented and most cited factors, namely Momentum, Value, Quality (Defensive), Carry, and Liquidity. We compare and analyze different factor definitions, as well as data sets that are used to conduct the corresponding research. Finally, we show how investors should pursue factor strategies to generate significantly higher risk-adjusted returns as well as to further diversify their portfolios.
Stocks vs. Corporate Bonds vs. Government Bonds
The concept of factor-based investing in the fixed-income space is still relatively less mature compared to equities, despite the obvious importance and relevance of the subject, and can no longer be denied by looking at current figures. These new approaches to fixed-income investing have sparked investors’ interest, particularly given the circumstances of rising rates in a low-yield environment.
Number of articles found via Google Scholar for the period from December 2000 until December 2017
We address this research gap and intend to give an overview of factors in government bond markets. These factors are often defined as investments that produce long-term returns using risk factors that are significant and unique, in the sense that they are not subsumed by other traditional risk factors. Such investment strategies are usually applied in a long-short or long-only (smart beta) manner. However, while the most popular applications of these factors are dedicated to the equity market, the extension of risk factors to non-equity markets has been an important trigger for empirical research in the modern asset pricing literature. Therefore, we clearly state in our review that factor investing in sovereign bond markets represents a new paradigm for a holistic portfolio construction process. The traditional market capitalization-weighted approach has often been criticized for its lack of diversification, especially in bond markets. It is questionable at best if fixed-income indices, in the way they are constructed, are representing what they are supposed to do as the level of indebtedness is not necessarily representative of the market as a whole. Therefore, factors like Momentum, Value, Quality, Carry, and Liquidity should not be neglected when constructing fixed-income portfolios as we observe strong support for the existence of significant factors in global government bond markets.
Based on our review of the literature, all examined factor strategies generate a significant alpha. While the corresponding positive returns can be captured through investing in each factor individually, employing multifactor portfolios produces more persistent and even higher risk-adjusted returns. This is mainly due to the low correlation between factors as well as the different market behavior of each factor across the business cycle. Therefore, multifactor portfolios provide not only a better, but also more efficient diversification than the previous solutions. Nevertheless, it is important to note that implemented strategy and factor definition preferences are not the sole variables that impact performance. Rather, the specific implementation designs like investment universe, rebalancing frequency, transaction costs, weighting scheme, and definition of portfolio configuration have a significant impact on performance and explains why two portfolios based on seemingly identical factors may perform differently.
The literature is not always clear on whether currency risk is hedged or left unhedged. As currency moves and volatility can be substantial, particularly in the short term, significant differences in performance between hedged and unhedged government bond portfolios can occur. The main criticism of factor outperformance versus conventional benchmarks points to higher risk exposure to duration and carry trade risk. However, as shown in our publication, the latest studies control for these exposures and document that the results remain almost unchanged. Additionally, when analyzing alphas of government bond portfolios (or funds) one should also consider the possibility of omitted risk factors as well as considering investable portfolios. While a theoretical long–short portfolio usually leads to higher risk-adjusted returns, implementing long–short sovereign bond portfolios is complex and infeasible due to operational difficulties and high transaction costs associated with shorting cash bonds, especially for illiquid bonds. Finally, our examined factors are also employed in other asset classes like stocks and corporate bonds.
For future research, the adoption of a unified asset pricing model that can be applied across asset classes may be worth considering. Additionally, future research should examine further significant factors that might impact the performance of government bond markets would lead to greater financial literacy in this rather underdeveloped field, thus furthering large investor attention.
Demir Bektić is a professor at the Technical University of Darmstadt and the International University of Monaco