by Paul Kovarsky, CFA, CFA Institute

Interest rates, as measured by the three-month Treasury yield, are the highest they have been in 10 years and trending higher.

Fixed-income investors are facing a conundrum. Some would call it crocodile jaws.

On top, the higher rate from the US Federal Reserve is slamming down on the value of bond portfolios. On the bottom, risk, as measured by duration and credit spreads on high yield, continues to rise.

Can smart beta help bond investors escape these jaws? We asked Salvatore J. Bruno and Kelly Ye, CFA, managing director and chief investment office, and director of research, respectively, of IndexIQ, a subsidiary of New York Life Investments, for their take on what’s next for bond investors. Bruno will be sharing some of these insights at the Inside Fixed income and Dividend Investing Summit in Newport Beach, California, on 13 and 14 November.

Below is a lightly edited transcript of our discussion.

CFA Institute: Why should investors allocate to fixed income in this environment?

Salvatore J. Bruno: There are important reasons to allocate into fixed income, even during periods of rising rates. Number one, it can provide diversification as a traditional hedge against equities.

Secondly, investors still do need income. Especially on the shorter end of the curve with rates in the US now in 2 to 2.25% range, yield is starting to become more attractive from an asset allocation standpoint.

Headline rates are starting to hit where inflation is at. We’ve dug out of the hole of negative real rates, so at least now you’re at zero, which may sound crazy, but it’s actually better than where we’ve been over the last 10 years.

Even on the long end of the curve, we’ve seen rates run up a little bit, topping at 3.25%. We’re not in the business of forecasting long‑term interest rates, but there is this school of thought that it may not go much higher than that. That may mean some future capital appreciation.

Credit spreads have remained fairly tight, generating some attractive returns in both investment grade — especially if you’re on the shorter end of the curve – and in high yield as well. We’ve seen a lot of higher returns, especially in some of the lower-quality credits.

Mutual funds still dominate fixed-income allocation. Why are ETFs playing a larger role in this space?

Bruno: Fixed income can be packaged rather neatly in ETF wrappers by systematizing some of the ways that active managers invest. We also try to move a little bit away from the traditional market capitalization-weighted indices.

That’s where the smart beta conversation starts to pick up. In many ways, it is similar to the rules‑based or smart beta approach on the equity side, by capturing the essential thought process that drives the portfolio management on security selection within the asset class. As well as systematizing in the ETF wrapper, we take some of the emotion and biases out of the investment process.

Smart beta solutions go back to Kenneth R. French and Eugene F. Fama’s research into equity factors. How do you construct smart beta ETFs in fixed income?

Bruno: Fixed income is a little bit of its own animal, different from equities. We do not look at factors and say, “Well, this factor works in equities. Can it work in fixed income?” but approach it from a solutions‑based standpoint.

What are some of the problems that fixed-income investors face? Are there ways that we can use traditional factors that have worked well on the equity side and apply them to fixed income?

For example, one of the factors we’ve looked at is the popularity and effectiveness of low-volatility investing on the equity side. Given the similarities between high‑yield corporate bonds and equities, we analyzed what happened in 2015 and 2016 when credit spreads blew out.

A lot of investors had been chasing yield because interest rates had been so low and really overpaid for high yield. We asked ourselves, “Is there a better way to do low-volatility investing in high yield?” We started thinking about this investor’s problem and what the solutions could be. Our answer is low volatility within high yield.

Kelly Ye, CFA: There are a few factors that work across asset classes because they are backed by sound economic or behavioral rationale. The graph below shows momentum, low vol, quality, and value are all factors that could work in both equities and fixed income. Quite a few papers show factor efficacy across asset classes, and active managers have long been using those factors in their investment process. The difference between factor application in equities and fixed income lies in their factor definition.

Factor Investing

To meet investor needs, active managers have been using factors to select securities for decades.

Factor Investing Chart Fixed Income

Use volatility for example: In equities, volatility is defined as either realizable volatility or the portfolio volatility taking into consideration correlation. In fixed income, not every bond is traded every day, so price volatility may be unrepresentative. Research existed almost 15 years ago that the volatility of a corporate bond may be measured by its duration and credit spread in a measure called DTS. It has now been widely used by active managers as a quantitative risk measure. It is derived from a bond’s market price, which is a more responsive measure than bond ratings

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