Out-performing corporate bonds indices with factor investing

Thomas Heckel
is co-head of the Quant Research Group at
BNP Paribas Asset Management in Paris, France.
thomas.heckel@bnpparibas.com, Tel. +33 (0)1 58 97 76 13

Zine Amghar
is head of Fixed Income in the Quant Research Group at
BNP Paribas Asset Management in Paris, France.
zine.amghar@bnpparibas.com, Tel. +33 (0)1 58 97 27 84

Isaac Haik
is a data scientist in the Quant Research group at
BNP Paribas Asset Management in Paris, France.
isaac.haik@bnpparibas.com, Tel. +33 (0)1 58 97 77 97

Olivier Laplénie
is head of quantitative fixed income portfolio management in the
Multi-Assets, Quant and Systematic team at BNP Paribas Asset Management in Paris, France.
olivier.laplenie@bnpparibas.com, Tel. +33 (0)1 58 97 23 31

Raul Leote de Carvalho

is deputy head of the Quant Research Group at
BNP Paribas Asset Management in Paris, France.
raul.leotedecarvalho@bnpparibas.com, Tel. +33 (0)1 58 97 21 83

August 25th, 2020

Electronic copy available at: https://ssrn.com/abstract=3697872

 Summary:

We considered a large number of factors from value, quality, low risk and momentum
styles and show that these factors can be used to select the corporate bonds with the highest
risk-adjusted returns. Our results were confirmed for the three largest corporate bond universes,
namely those defined by U.S. Investment Grade, Euro Investment Grade and U.S. High Yield
benchmark indices. The factors we investigated can be used to create investment strategies
designed to out-perform these benchmark indices by overweighting the cheapest bonds with
the strongest performance trends from the most profitable, better managed and less risky
companies.

Keywords: factor investing, smart beta, corporate bonds, credit, factor premiums, high
yield, investment grade, low-risk, value, momentum, quality

JEL Classification: G11, G12, G14, E44

Electronic copy available at: https://ssrn.com/abstract=3697872

 Factor investing

Factors are characteristics of companies that can be used to compare a company with its
peers. Factors tend to be classified into different styles: value, quality, low risk and momentum.
Value factors measure how cheap a company is, quality factors measure how profitable and
well managed a company is, risk factors measure how risky a company is and momentum
factors measure how a company has been performing in the financial markets relative to its
peers.

For equities, these four styles of factors - value, quality, momentum and low risk – have
been receiving considerable attention for decades because they can be used to pick the stocks
with the highest returns and to design strategies that on have been out-performing market
capitalisation indices over time. Cheaper stocks with the strongest past returns and from the
most profitable, better managed and less risky companies tend to out-perform. Thus, strategies
that overweight such stocks relative to the market capitalisation benchmark indices tend to out-
perform at least when sector, regional, size and market exposure biases relative to the
benchmark index are avoided.

The likely sources of factor premiums

While the existence of factor premiums is now recognised by academics, there is still a
debate as to which extent these result either from risk exposures or from market inefficiencies.
We believe there are strong reasons to expect market inefficiencies to play an important role in
explaining the existence and persistence of factor premiums. Some key examples of market
inefficiencies that can explain factor premiums include:
i) Market structure: some structural characteristics of credit markets can explain inefficiencies.
In particular, we note that the objective of some market participants, e.g. central banks, is not
necessarily the maximization of returns and this can create inefficiencies.
ii) Investor behavioural biases: human behavioural biases are likely to affect investment
decisions, driving investors to disregard or misuse information when investing. Over-
confidence, i.e. the tendency for people to see themselves better than the average, or
representative bias, i.e. the idea that people tend to rely more on anecdotes than statistics, are
just two examples of such biases.
iii) Investor constraints: market inefficiencies can also result from constraints that apply to the
portfolios of many investors. On example is restrictions on the leverage investors can use, which
may arise because of bankruptcy laws that cap the amount lenders are willing to lend, or because
of risk constraints the lenders impose on themselves, or even because of leverage aversion from
the side of investors. Another example is short-selling constraints limiting the ability of some
investors to arbitrage the market inefficiencies. Such constraints may arise from regulatory
constraints, or from the availability of financial assets to short-sellers. Other typical constraints
include caps on regional or sector exposures, limits on issuer rating exposures, or aversion to
turnover.

Factor investing for corporate bonds

It is remarkable that not much attention has so far been devoted to assessing to what
extent style factors like value, quality, momentum and low risk can also be used to design

Electronic copy available at: https://ssrn.com/abstract=3697872

strategies capable of out-performing corporate bond benchmark indices. After all, the volume
of corporate debt just reached an all time high in real terms of USD 13.5 trillion at the end of
2019 according to the OECD.

This, however, may be changing. Leote de Carvalho et al. (2014) were the first to
provide compelling empirical evidence that low risk factors are predictive of future bond excess
returns at bond issue level. They gave empirical evidence that lower risk corporate bonds not
only have an ex-post lower beta relative to the market capitalization-weighted benchmark index
but also deliver higher risk-adjusted returns. Their results were confirmed independently for
corporate bonds denominated in USD, EUR, GBP and JPY, in a study that also considered
many other segments of fixed income.

Houweling and Zundert (2017) went beyond low risk and gave evidence that factors
from the value and momentum styles are also predictive of future bond excess returns at issue
level. Their analysis focussed on the U.S. investment grade (IG) and U.S. high yield (HY)
universes separately. They used relatively simple factors. For the value style they used a fitted
fair value credit spread calculated from a regression across all bonds at a given date on ratings,
time to maturity, and the three-month spread change for each bond. Cheap issues would show
the actual credit spread above the fitted one. For the momentum style they used the six month
return of each issue in excess of duration matched treasuries, lagged by one month. However,
their analysis did not including factors that require fundamental company data.

Israel et al. (2018) also investigated factors that rely on fundamental data. They
demonstrated empirically that value, momentum, low risk and quality factors are predictive of
future excess returns of U.S. corporate bonds, IG and HG combined. In particular, they used
the company profitability in the quality style. However, in their study, Israel et al. did not use
the entire issuer curve but just one bond per issuer.

More recently, in a paper about the four factor styles, Heckel et al. (2019) considered a
large number of factors and, for the first time, with many of them based on fundamental data.
They showed that factors from the value, quality, low risk and momentum styles can be used to
select the bonds with the highest future risk-adjusted returns and to design strategies that out-
perform the market capitalisation benchmark indices.

Differences between equity and corporate bond factor investing

Factor investing in corporate bonds is, however, not as straightforward as for equities
and there are a number of differences that need to be taken into account. First, for each company
there may be many bonds with different maturities and specifications, and hence with different
risk. Second, the risk of each bond changes as time passes because the time-to-maturity
decreases. Third, corporate bonds trade in fragmented and opaque over-the-counter (OTC)
markets. Fourth, corporate bonds offer relatively poor liquidity and many are difficult to trade
since many investors buy and hold them until maturity. Fifth, unlike stocks, where investors
may expect to earn outsized returns from companies that see their market capitalization growing
significantly over time, the returns earned by bond investors lending to those same companies
is not going to be as significantly impacted by the growing equity capitalization. A company
growing in market capitalization may simply grow its debt by issuing more bonds without any
visible impact on the returns earned by current bond holders.

Electronic copy available at: https://ssrn.com/abstract=3697872

 All these questions need to be addressed when designing factor investing strategies for
corporate bonds. An additional difficult arises from the fact that constructing factors based on
fundamental data is also more difficult for corporate bonds than for equities because it requires
linking the pricing data of the many individual bonds issued by a given company to its
fundamental characteristics in a robust manner. The fact that a particular bond keeps its name
through maturity even when its issuer company changes name, e.g. because of merger or
acquisition, adds to the difficulty of creating such link, in particular since relying on CUSIP
and tickers is not sufficient to produce good coverage and a reliable history.

The data
We considered separately the three largest corporate bond universes: U.S. investment
grade (IG), Euro IG and U.S. high yield (HY). Performing the analysis on three separate
universes allows us to test for the robustness of the results while limiting data snooping. We
used a total of 33 factors across the four styles - value, quality, low risk and momentum, which
also help reducing data snooping as we do not keep only what has performed the best but,
instead, we keep all factor ideas as listed in exhibit 1.

Exhibit 1: list of factors classified into styles

Prefer
Factor high/low
Description Factor
style factor
values
Prefer cheaper firms Spread relative to distance to default high
Book to price low
Cash-flow to price low
Value
Avoid value traps Reported earnings to price low
IBES earnings forecast to price low
Sales to price low
Cash-flow to debt high
Free cash-flow to debt high
Prefer firms capable
Gross profit to debt high
of covering debt
EBITDA to debt high
with generated
EBITDA to interest expenses high
income
Quality Accruals (Op) to total assets low
Accruals (Fr) to total assets low
Capital expenditures relative to total assets low
Avoid aggressive Change of debt relative to total assets low
issuers Financing cash to debt low
Annual percentage change in total assets low
Prefer less indebted Leverage low
firms Distance to default high
Low risk
Prefer less risky Stock beta (historical 3-year weekly returns) low
firms Stock volatility (historical 3-year weekly returns) low
12 months – 1 month momentum high
Prefer firms with 12 months – 1 month alpha high
stronger medium-
12 months – 1 month information ratio high
term equity
12 months – 1 month Jensen information ratio high
momentum and
6 months – 1 month momentum high
weaker short-term
equity momentum Momentum relative to the 52 weeks high high
Momentum
1 month reversal momentum low
6 months momentum in earnings revision high
Prefer firms with
12 months momentum in earnings revision high
stronger
Annual change in standardized IBES long term earnings growth forecast high
fundamental
Annual change in standardized earnings high
momentum
Annual change in standardized free cash-flow high

Electronic copy available at: https://ssrn.com/abstract=3697872

 A number of the factors considered use fundamental data taken from the Worldscope
database for companies and from the IBES database with analysts’ forecasts of fundamental
data. Both databases were linked to the ICE BofA database to ensure the link of each bond to
its obligor through time. This required carefully taking into account the impact of mergers and
acquisitions throughout history. A proprietary methodology for linking the different databases
was used for this purpose.
For the bond returns, we used data from the ICE BofA database. The data is free of
survivorship bias: whenever a company defaults, the returns of its bonds are based on their final
traded price, reflecting the market’s expected recovery rate. The excess returns from each
corporate bond versus duration-matched Treasuries are provided. Market value, time to
maturity, credit rating and credit spread are also provided.

The factors for corporate bonds

We used factors derived from factor ideas from the equity markets while adapting them
to the corporate markets using intuitive arguments. In some cases, this requires significant
changes in terms of the way the information is used as explained below.
The value style is about investing in cheap securities. We considered two types of value
factors. The first favours bonds with a larger option-adjusted spread (OAS) relative to a fair
value OAS obtained from a regression of the OAS of bonds against their time to maturity and
distance to default. Bonds with an OAS larger than fair value OAS are undervalued. The second
type of value factor aims at identifying value traps, i.e. companies that may appear to be cheap
based on traditional value measures such as book-to-price, cash-flow yield, earnings yield or
sales yield, but are in fact cheap because they are closer to default. Avoiding the companies
with the larger values of these ratios will likely exclude such companies. While for equity
investors this may sound counter intuitive, bond investors do not capture an upside: they just
earn the yield for as long as there is no default. Thus, between two bonds with the same spread
and duration, we prefer the bond of the company with a higher price being paid by equity
investors for its book value, earnings or cash-flow because equity investors are pricing a lower
probability of default by showing confidence in the future of the company.
For the quality style we also consider two types of indicators. The first measures the
ability of a company to cover its debt with generated income. We prefer companies with more
cash-flow, profits and earnings relative to their debt or to their expenses. We also prefer bonds
from companies with lower accruals relative to assets. A second type of quality indicator avoids
aggressive businesses. We avoid companies with increasing expenditure or debt relative to their
assets, or with lower amounts of cash relative to debt.
The low risk style is about earning higher risk-adjusted returns from lower risk
companies. We used two types of risk measures. First we prefer bonds of companies with lower
leverage and lower distance to default. Second, we prefer bonds from companies with lower
equity beta and lower historical volatility of stock returns.
For the momentum style, we use two types of momentum. The first is based on the
performance of the company in the equity markets. Much like for stocks, we prefer bonds from
companies that outperform their peers in the equity markets in the medium term (six to 12-
month horizon). But in the short term, we prefer bonds from companies that just
underperformed, as it is the case for equities. Jensen information ratio is the average of the
residuals of a regression of stock excess returns against market capitalization index excess
returns divided by the volatility of those same residuals. The second type is fundamental

Electronic copy available at: https://ssrn.com/abstract=3697872

momentum. We prefer bonds from companies with stronger earnings revisions momentum, a
stronger annual change in long-term earnings growth forecasts standardized by the annual
volatility of those same forecasts, a stronger annual change in earnings per share standardized
by the volatility of the annual changes in earnings per share, and an annual change in free cash-
flow standardized by the volatility of the annual changes in free cash-flow.

Proprietary factor modelling approach

The success of factor investing in corporate bonds is strongly dependent on controlling

for known risk variables in particular OAS, duration, size and sectors. We used a modelling
approach called local scoring which, proposed by Heckel et al. (2019), that does just that in a
rather simple and efficient way and that is superior to other alternative approaches such as
stratified sampling or optimisation. It is based on comparing each bond only to bonds with a
similar risk profile. This new approach can be seen as an improvement of stratified sampling.

Table A) ICE BofAML U.S. IG Corporate bond index (C0A0)

Benchmark Investable universe Coverage of investable universe

Date Bonds Issuers Bonds Issuers Bonds Issuers
Jan. 2002 3567 676 1589 417 80% 85%
Jan. 2010 4026 769 1959 534 88% 85%
May. 2019 7694 1156 4271 843 87% 80%

Table B) ICE BofAML Euro IG Corporate bond index (ER00)

Benchmark Investable universe Coverage of investable universe

Date Bonds Issuers Bonds Issuers Bonds Issuers

Jan. 2002 1082 248 616 196 76% 72%
Jan. 2010 1764 389 856 291 77% 77%
May. 2019 3125 681 2010 523 76% 76%

Table C) ICE BofAML U.S. HY Corporate bond index (H0A0)

Benchmark Investable universe Coverage of investable universe

Date Bonds Issuers Bonds Issuers Bonds Issuers

Jan. 2002 1799 363 494 144 38% 65%
Jan. 2010 1911 847 706 361 54% 61%
May. 2019 1796 861 892 486 74% 67%

Table A) Number of bonds and issuers in the ICE BofAML U.S. IG Corporate bond benchmark
index at different dates as well as number of bonds and issuers that were investable at those
same dates, and percentage of those bonds and issuers that were covered by factor data. B)
Same for ICE BofAML Euro IG Corporate bond benchmark index and C) same for ICE
BofAML U.S. HY Corporate bond benchmark index. Datasources: ICE BofAML, Bloomberg,
FactSet, Worldscope and IBES.

Electronic copy available at: https://ssrn.com/abstract=3697872

 The preparation of the study

Before simulating the historical performance of the factor strategies, we first filtered the
universe starting by removing all non-senior debt from the respective ICE BofA index. This is
important because these bonds are not comparable to senior bonds. We also remove bond with
the longest time to maturity, because there are too few of them, and illiquid bonds, such as
bonds with low face value bonds or bonds with stale prices. In May 2019, the filtered universe
for U.S. IG was composed of 7,694 bonds from 1,156 issuers. 4,271 of these bonds from 843
issuers were investable. Data was available to construct the factors for 87% of those investable
bonds and for 80% of those issuers. Similar data for the U.S. IG universe can be found in table
A). Similar data for Euro IG and for U.S. HY can be found in table B) and table C),
respectively.

The results

For each universe, we carried out historical simulations of strategies built from the
factors in Exhibit 1, monthly rebalanced. The portfolios for each style are obtained by equally
weighting each factor in each style while using our proprietary approach, the local scoring
approach. For all, we equally weight each of the four styles. The factors were used to identify
and buy the issues with higher expected risk-adjusted returns, while selling the issues with the
lowest expected returns.

Exhibit 2: alpha, tracking error (TE) and information ratio (IR)

in excess of treasuries returns and sector, OAS, duration and size neutral.
U.S. IG Euro IG U.S. HY
Alpha TE IR Alpha TE IR Alpha TE IR
Value 2.8% 1.4% 2.01 1.1% 0.6% 1.70 4.1% 2.6% 1.60
Quality 1.1% 0.9% 1.24 0.5% 0.6% 0.81 1.5% 1.9% 0.78
Low Risk 2.6% 1.6% 1.66 0.9% 0.7% 1.22 2.7% 2.9% 0.92
Momentum 2.8% 1.2% 2.25 1.5% 0.7% 2.09 3.5% 2.4% 1.45
All 3.7% 1.7% 2.23 1.6% 0.8% 1.97 4.6% 2.9% 1.59

In Exhibit 2 we show results from the simulations. These include the average annual
alpha generated over time from the factor strategies divided, the tracking error, i.e. annualized
volatility of this alpha, and the information ratio calculated from dividing the alpha by the
tracking error. In the regression used to calculate the alpha, we used the monthly returns
generated from the historical simulations against the returns of the equally weighted universe.
The returns used for each corporate bond to generate the results are all in excess of duration-
matched Treasuries. For the U.S. returns are in USD and for the Euro region in EUR. No
transaction costs were included. The simulations run from Jan-00 through May-20.

In exhibit 3, 4 and 5, we plot the sum of the monthly alphas for the aggregation of
factors in each factor style and for the aggregation of all factors for all three universes
considered, respectively. All factors styles added to performance of the underlying strategies,
although in the period, the quality factors added less than the other styles. The diversification
effect arising from combining the four factor styles explains the better performance of the
curves including all styles. Finally, the results show good performances also during crisis
periods. In fact, it is in such periods that the excess returns tend to be larger.

Electronic copy available at: https://ssrn.com/abstract=3697872

 9

Electronic copy available at: https://ssrn.com/abstract=3697872

 Conclusions

Factor investing in corporate bonds is still relatively new in particular when compared
to factor investing in equities. We have demonstrated that value, quality, low risk and
momentum are factor styles that can also be used to construct investment strategies that out-
perform the market capitalisation indices for U.S. IG, Euro IG and U.S. HY.
We used factors derived from the equity markets while adapting them to the corporate
markets using intuitive arguments. We also propose a new proprietary approach to factor
modelling particularly adapted for factor investing in corporate bonds that allows for easy
control of the many undesired risk exposures of each bond, namely OAS, duration, size and
sectors. Using numerical historical simulations we demonstrate the significance of our results
for the three investments universes considered: U.S. and Euro Investment Grade and U.S. High
Yield.
In terms of applications, we believe that factor investing in corporate bonds is
particularly promising as a diversifier of traditional active management, which more often than
not relies on taking spread, duration and sector views. It is also promising as an alternative to
passive investing in corporate bonds. In particular since corporate bonds benchmark indices can
be difficult to replicate because of the lack of liquidity of many bonds and also because these
indices tend to have high levels of turnover as a consequence of the dynamic nature of the
corporate bond markets, with steady streams of new issues, repayments, maturities and rating
changes.

Disclaimer
The views and opinions expressed herein are those of the authors and do not necessarily
reflect the views of BNP Paribas Asset Management, its affiliates or employees.

10

Electronic copy available at: https://ssrn.com/abstract=3697872

 References
Heckel, T., Z. Amghar, I. Haik, O. Laplénie, and R. Leote de Carvalho. 2019. “Factor
investing in corporate bond markets: enhancing efficacy through diversification and
purification!” The Journal of Fixed Income, forthcoming.
Houweling, P., and J. van Zundert. 2017. “Factor Investing in the Corporate Bond
Market.” Financial Analysts Journal 73 (2): 100-115.
Israel, R., D. Palhares, and S. Richardson. 2018. “Common Factors in Corporate Bond
Returns.” Journal of Investment Management 16 (2): 17-46.
Leote de Carvalho, R. L., P. Dugnolle, X. Lu, and P. Moulin. 2014. “Low-Risk
Anomalies in Global Fixed Income: Evidence from Major Broad Markets.” The Journal of
Fixed Income 23 (4): 51-70.

11

Electronic copy available at: https://ssrn.com/abstract=3697872