Fixed Income Smart Beta: An Evolutionary Tale
While it has not been completely “stealth-like” in nature, the evolution of the fixed income market over the last couple of years seems to have gone at least a little bit under the radar. Indeed, the emergence of what is called “smart beta” in the equity arena has certainly garnered its share of headlines, but this movement in fixed income is just gaining momentum and promises to be the next step in the evolution of solutions for bond market investing.
In broader terms, fixed income smart beta strategies seek to address—perhaps correct is the better term—the counterintuitive features that are a hallmark of market cap-based investing. WisdomTree has been at the forefront of smart beta for some time and has applied this methodology in the fixed income universe utilizing two distinct approaches: yield-enhanced core strategies and fundamental corporate strategies. Let’s think of them as Smart Beta v. 1.0 and Smart Beta v. 2.0, respectively.
Highlighting WisdomTree Fixed Income Smart Beta Solutions
The inherent flaws in the market cap-based approach to fixed income were fully evident in the realities and reaction to the financial crisis and Great Recession of 2007–2009 and highlight the need for an alternate or improved approach. Specifically, aggressive central bank policies, such as quantitative easing (QE), along with subpar growth and a lack of inflation, all served to push yield levels to historically low readings, where they continue to reside. As a result, low-yielding government bonds have risen to visibly over-weight positions in global bond indexes, subjecting fixed income investors to sacrificing income and heightened interest rate risk at the same time. The search for income in this yield-starved environment can lead to a riskier approach: moving out on the maturity curve (duration risk) and/or going down in credit quality (credit risk).
The WisdomTree yield-enhanced, or Smart Beta 1.0, rules-based strategy is more macro based in nature and focuses on core investing. It reweights the sectors of an existing index in order to boost income potential while maintaining a familiar risk profile. It generates over-weights to investment-grade credit and under-weights Treasuries, and it also comes in a “short-term” version for investors who wish to mitigate the potential for higher rates.
The WisdomTree fundamental corporate, or Smart Beta 2.0, rules-based approach has more of a micro and security-level focus. The first part of the process defines the universe, employing a stringent issue- size criterion and including only public issuers domiciled in the U.S. The emphasis then shifts to the balance sheet, where factors that have worked consistently over time, such as free cash flow over debt service, leverage ratio and return on invested capital, are used to screen for quality. The process then tilts the weighting toward bonds with more favorable income characteristics.
The landscape for fixed income investing in the U.S. promises to remain a challenging one as we look ahead. The prospects for rates remaining relatively low, the Federal Reserve (Fed) beginning to normalize policy and uncertainty in the fiscal policy outlook all combine to create an environment in which bond investors will no doubt be searching for “smarter” fixed income solutions.
Important Risks Related to this ArticleFixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.