If the call for greater innovation in fixed income ETFs as discussed by EDHEC Risk Institute in its recent investor survey is to be answered then the asset class most likely to provide some of the answers is corporate bonds.
The type of diversification already achieved in equity ETFs is yet to be seen in fixed-income. “There is still a gap,” according to Lionel Martellini, Professor of Finance at EDHEC Business School. “This investment will develop in the near future, as soon as the offer matures and better matches investors’ needs.”
In fact, this could all change quite rapidly, particularly given the equity-like characteristics inherent in corporate bonds and the potential for applying factor investing techniques.
“Corporate bond smart beta is similar to equity smart beta, but more I suspect because the same human traits of greed and fear drive the corporate bond market that drive the equity markets,” says Peter Sleep, senior portfolio manager at 7IM.
“For instance, investors tend to avoid low risk securities and prefer gambling chips which gives us the minimum variance factor in equity and fixed income, or investors can be slow to react and accept new investment information which gives the momentum factor.”
Echoing Sleep’s views, Nicolas Rabener, managing director of FactorResearch, suggests with factors clearly applicable across asset classes, it is only natural that ETF providers should roll-out the same strategies in all asset classes, either as single-factor or multi-factor products.
“The factor definitions vary slightly when moving from equities to bonds, but it is still mostly the same strategies, like value, momentum, or quality,” Rabener adds.
As with equities, there is choice available in corporate bonds, and with the potential for factor to find value in return for certain risk premia.
“There are far more choices to be made when selecting individual bonds for inclusion within an index,” says Irene Bauer, CIO at Twenty20 Investments. “It would seem reasonable to believe that a certain sub-set of these have been systematically undervalued providing a better return when only using that filtered set.”
Though with a similar risk-profile to equities, the returns on corporate bonds are less volatile. According to Sleep, while equities might yield 5-6% over cash, corporate bonds are between 1-2% over cash over time. This can be ‘juiced up’ if looking only at high-yield corporate bonds where the return – and the risk – is more equity-like.
However, as Rabener notes what should be the case with returns on corporate bonds – that 1-2% return over cash – is not currently happening in Europe, at least. “In Europe, the current issue is that corporate bonds from high-quality issuers like Nestle, similar to government bonds, are showing negative yields,” he says.
“Globally the quality of corporate bonds has deteriorated in recent years as investors have been lenient on covenants and overall corporate leverage increased given an unquenchable thirst for yield.”
Hence, as Sleep suggests, the potential for investors to “dial up” the risk and look towards high yield.
“Then you can expect a bit more of a return which is more equity-like,” he says. “I do not think anyone is pretending to shoot the lights out with corporate bond smart beta, but I would hope to see about 1% a year after fees over the course of the cycle. However, given the low yields investors endure today, every little helps.”
The question with smart beta corporate bond funds as with smart beta generally is what does utilising this approach offer that is different from going down the pure alpha route. One point, of course, it that of cost. As Rabener notes, fund managers have been applying styles to select corporate bonds for many decades; smart beta is simply offering a systematic version of this at a lower cost.
Yet the strategies deployed will effectively be the same. “Smart beta funds will try to access additional information (such as the fundamental data used for equities) to determine which bonds are undervalued having a too high credit spread – or equally which credit spreads will likely go down in the future,” says Bauer.
As long as these funds provide a more consistent and explainable performance, Sleep is happy. “I own several smart beta bond funds and I would say that if anything stands out the smart beta funds tend to be more plain vanilla, in that they do not seem to get as involved in complicated derivative strategies or involved in less liquid areas of the market that I often see in active funds,” he says.
Dumb and dumber
Plain vanilla sounds less attractive as a marketing term than smart beta or the other pejorative term that gets flung in its direction, dumb alpha. This is the idea that smart beta ‘merely’ delivers exposure to well-known strategies that actually represent little by way of intellectual property.
“Although this is true, it is unfortunately the only way of trying to generate outperformance,” says Rabener. “Active management, which underperforms in the short-, medium, and long-term, is not a solution.
“Naturally corporate bond fund managers, like their desperate counterparts in equities, will emphasise the value of active management.
“Although fixed income markets do have some structural differences to equity markets, there is little evidence that active managers generate significant alpha in corporate bond markets. In almost all cases, low cost beats active management.”
Given the fact technology and rules-based processes can now do much of the “heavy-lifting’, it is not surprising that billions of assets have piled into equity-based smart beta products, says Bauer. And there is every reason to suspect that the same rush of money will be seen in corporate bonds. “Based on that it would be dumb of the business community to not try to repeat that success in the fixed-income space,” she adds.
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