Factoring Factors Into Bond ETFs

One of the most frequently asked questions about smart beta funds is when fundamentally weighted methodologies will permeate the fixed income space in earnest. More than 1,000 smart beta exchange-traded funds (ETFs) trade in the U.S., but a small percentage are bond funds.

That percentage is growing as advisors and investors are clamoring for new ways to access bonds. Traditional bond ETFs are cap-weighted, meaning issue size is taken into account when weighting components in bond indexes, much the same market capitalization is used in equity benchmarks. The result is aggregate bonds that usually excessively allocated to U.S. government debt and corporate bond ETFs that are heavily allocated to the largest issues.

A new wave of bond funds are bringing alternative weighting methodologies to life, including the iShares Edge Investment Grade Enhanced Bond ETF (IGEB). IGEB, which tracks the BlackRock Investment Grade Enhanced Bond Index, debuted earlier this year.

Factors Work With Bonds, Too

Investment factors, such as momentum, quality and value, are often applied to and thought of in relation to stocks, but factors have applications with bonds, too.

“Combining quality and value is thus intuitive,” said BlackRock. “Applying a quality screen to the market can remove those securities with the highest expected chance of defaulting, resulting in a higher quality universe of securities from which to build a portfolio. Bonds are then chosen using a value tilt, picking the higher value names after the worst have been removed.”

IGEB holds 230 bonds and has a 30-day SEC yield of 4.29%, which is in line with traditional corporate bond funds. The ETF has an effective duration of 6.86 years.

Multi-Factor With Bonds

One of the fastest-growing areas of the smart beta space is multi-factor funds. A simple explanation of multi-factor ETFs is that these funds employ multiple investment factors, such as low volatility, quality and value, in one fund. This methodology can be applied with bond funds and to the advantage of investors.

Applying quality to bonds can help limit default risk, but that factor on its own can potentially weigh on yield and a bond portfolio's long-term returns. There are pros and cons to emphasizing value with bonds, too.

“With the value factor, we see almost the reverse dynamic at play,” said BlackRock. “Tilting toward value can create a portfolio of high yielding securities relative to the broad market. However, these higher yielding bonds are often the most risky, resulting in a lower risk-adjusted return than the broad market. The value portfolio could generate higher returns and yields but not without the cost of higher risk. This may not be palatable to fixed income investors, especially those who rely on their bond portfolio as a source of relative safety and stability.”

Nearly 98% of IGEB's holdings are rated A or BBB, indicating quality is at play, but the ETF's yield of almost 3.4% indicates investors are not being cheated out of income to access solid credit quality.

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