For a while now, the news for fixed-income investors has not been encouraging. Yields have been at historic lows, which means less income rolling into the portfolio. Some investors have tried to remedy this situation by either going farther out on the curve—buying bonds with longer maturities—or accepting greater credit risk by buying debt obligations with lower credit ratings in order to capture higher interest rates.
But interest rates don’t tell the whole story about opportunities in the fixed-income markets. In structuring a bond portfolio to both capture higher total return and retain more stable value, there are multiple factors that should be taken into consideration. In addition to the bond’s current yield (its total return to maturity, based on purchase price and interest payable), it’s also important to look at expected capital appreciation or depreciation prior to the bond’s maturity date, its expected future change in yield, and the credit-worthiness of the issuer (which can predict the likelihood of default and the related likelihood of recovery, given default). By studying all these factors and correlating them with the information presented in the bond’s forward rate (current yield and expected appreciation/depreciation), it is possible to make systematic decisions about fixed-income portfolios that rely more on observable factors and less on attempts to find mis-priced bonds or predict the future direction of interest rates.
But how can an investor determine which of the several available factors to pay most attention to? To answer this question, analysts at Dimensional Funds performed a study of more than 17,000 corporate bonds from issuers both in the US and other countries. The sample included bonds with investment-grade ratings (BBB or higher) and also high-yield bonds with ratings as low as B. In addition to the factors described above, they also analyzed the issuer’s use of leverage and previous 6–12-month performance of the issuer’s common stock, including its short-term returns.
The analysts discovered that most factors do not provide information about expected bond returns that is not already contained in the bond’s forward rate information: its current yield and expected capital appreciation/depreciation prior to maturity. While bonds’ short-term equity returns do correlate highly with bond returns for a short period of time, the correlation decays quickly, which means that capturing any expected premium would likely involve excessive trading costs and would thus not be cost-effective for the investor.
The forward rate, by contrast, tends to both correlate well with expected returns and maintain that correlation over a longer period of time. In this way, the forward rate factor serves as a much more reliable indicator of total return, without requiring the type of trading velocity that erodes those returns. Such a systematic approach to fixed-income portfolio construction may be expected to offer investors the flexibility to navigate market conditions in a disciplined and cost-effective way.
At Empyrion Wealth Management, we help family stewards and other investors apply research-driven, evidence-based strategies in order to achieve their most important long-term goals. To learn more, click here to read our recent article, “Active, Passive, or Both?”
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