The abundance of theoretical and empirical research on factor investing in the equity universe stands in sharp contrast to the relative scarcity of research about how to efficiently harvest risk premia in bond markets. That relatively little is known about the out-of-sample performance of factor-based bond portfolio construction methods is perhaps surprising given the importance of fixed-income investments in institutional and private investors’ portfolios. From the investment practice standpoint, a similar contrast actually exists between factor investing in the equity space, which is a relatively mature subject, and factor investing in bond markets, which still is in its infancy. It is indeed fair to say that the so-called smart beta approach is now firmly grounded in equity investment practices, and the key question for an increasing majority of institutional investors is not whether one should use smart beta, but instead which and how much smart beta to use. In parallel, interest in smart beta equity products is rapidly growing in retail and private wealth management. In contrast, the concept of smart beta in the fixed-income space is still relatively less mature (see the article published in l’AGEFI), despite the obvious importance and relevance of the subject. Trying to apply smart beta equity strategies to bond portfolios would not be the relevant approach. For example, one of the most popular smart beta equity strategies is to construct a low-volatility portfolio, which is achieved by focusing on low-volatility stocks. However, it is unclear whether a minimum-volatility smart beta bond strategy would make any sense. Lower volatility would mean constructing a portfolio with lower-volatility bonds, which would result in a portfolio that is heavily skewed toward bonds with short maturities from issuers with the lowest credit risk, a strategy that would not be appealing to most investors. A dedicated analysis of risk premia in bond markets is therefore critically needed for the emergence of truly meaningful smart factor investing solutions in the fixed-income space.
It should be noted that we address the question of factor investing from the perspective of a single credit-risk-free issuer, which is a priori the purest and most difficult problem since neither time-series nor cross-sectional differences in risk and performance can be explained by differences in credit worthiness, as in the case of a multi-issuer universe. We can distinguish two categories of factors:  factors that are relevant from a time-series perspective, i.e., factors such as the “level” or “slope” of the yield curve that explain for any maturity a large fraction of differences over time in bond returns and (2) the factors that are relevant from a cross-sectional perspective, i.e., factors such as “value” or “momentum” that explain at any point in time a large fraction of differences in the cross-section of bond returns.
In a first companion paper, we propose a detailed empirical study of implementable unconditional and conditional carry strategies in the US Treasury market to assess whether the level factor remains conditionally and unconditionally rewarded when strategies are implemented using actually traded bonds rather than “virtual” discount bonds. Using a comprehensive database of individual CUSIP bond returns in the US over the 1973-2018 sample period, we find that a conditional version of a carry strategy based upon a time-varying exposure to the level factor can generate excess performance of up to 200 basis points. Using yield curve data, we also find that a conditional version of a flattener strategy based upon a time-varying exposure to the level factor can generate economically significant additional performance, even though such excess performance is limited in implementation by the presence of leverage constraints. Overall, our results suggest that even in a single-issuer universe with highly correlated bond returns, and after accounting for transaction costs, factor investing can allow for an efficient harvesting of economically significant level (duration) risk premia.
In two other companion papers (Maeso, Martellini and Rebonato (2019)), we will present a related analysis of factors such as “value”  and or “momentum”  that are relevant from a cross-sectional perspective, using economically justified proxies for these attributes. In , we propose a definition of value in Treasury bonds that, we believe, is more satisfactory than definitions found in the recent literature, and that allows for statistically significant and economically relevant predictions of cross-sectional excess returns. Our value pricing factor exploits the differences between the market and the theoretical values of Treasury bonds, where the theoretical value is assessed using an economically justifiable Gaussian dynamic term structure model. We show that the trading strategy we build using our value signal is profitable and closely linked to the Treasury market volatility. In , we undertake a systematic, security-level analysis of momentum and reversal strategies in US Treasuries covering more than 40 years of data. We find that, after adjusting for duration, the long/short (zero-cost) reversal cross-sectional strategy is profitable over a wider range of look-back and investment periods. This strategy can be adapted to a portfolio (long/only) context.
In terms of further research, we expect to explore the implications of our results for the construction of global sovereign bond benchmarks, taking the analysis from the single- to the multi-issuer setting. Finally, we will extend the analysis to corporate bond markets in order to investigate whether economically significantly risk premia can be harvested despite higher implementation hurdles.
This research is drawn from the Amundi ETF, Indexing and Smart Beta Investment Strategies research chair at EDHEC-Risk Institute.
Related publications, from the least to the most technical:
An article in l’AGEFI on smart beta strategies in fixed income universes with an interview of Riccardo Rebonato, professor of finance at EDHEC Business School.
An article in IPE dealing studying the duration risk factor on a real US CUSIP bond universe.
Three forthcoming EDHEC-Risk Institute Publications, stay tuned to the EDHEC-Risk Linkedin page for the release of the publications in May/June :
Maeso, J., L. Martellini, and R. Rebonato. 2019. Factor Investing in Sovereign Bond Markets -Time-Series Perspective. EDHEC-Risk Institute Publication.
 Maeso, J., L. Martellini, and R. Rebonato. 2019.Factor Investing in Sovereign Bond Markets: Defining and Exploiting Value in Bonds. EDHEC-Risk Institute Publication.
Maeso, J., L. Martellini, and R. Rebonato. 2019. Factor Investing in Sovereign Bond Markets: Cross-Sectional and Time-Series Momentum in the US Sovereign Bond Market. EDHEC-Risk Institute Publication.