Fundamental Corporate Bond Strategies: Why We Tilt Weights toward Income

In our previous discussions about our approach to fixed income indexing, we focused primarily on the fundamental side of our research. By screening bonds based on select fundamental factors, it would have been possible to boost risk-adjusted returns. While we believe this to be significant, we also understand that many investors ultimately allocate to bond strategies for income. Therefore, even though expected total returns may appear compelling, tilting toward higher quality often involves a sacrifice in yield. In this discussion, we seek to acknowledge this potential challenge to indexing and explain our approach to overcome it. Figure 1 below illustrates the yield sacrifice that a quality approach to fixed income has encountered over time.¹ As expected, when we apply fundamental factors to remove lower-quality credits, we become more defensive and lower yielding. While the yield sacrifice for investment grade appears modest, the average level of spreads during this period (including the global financial crisis) is approximately 160 basis points (bps).² In the case of high yield, the reduction in yield can be meaningful. However, investors should recall that a quality approach to high yield boosted total returns by 130 bps per year despite the sacrifice in yield.³   Figure 1: Calendar-Year Yield Differentials (in basis points) [December 31, 2002 – December 31, 2016] During a rally when spreads tighten aggressively, lower-quality bonds may generate significant outperformance, which a strict quality strategy may not capture. In order to overcome this potential shortfall, we describe our process to enhance the income profile of the strategy in the second step described below.   The Income Tilt: Balancing Quality With Value To implement the income tilt, we first establish an income score for each bond. The income score calculates a bond’s incremental income, as proxied by the option-adjusted spread, adjusted by multiple risk factors, including probability of default, interest rate risk⁴ and potential recovery values. In this step of the process, we are seeking to enhance the incremental income of the strategy while continuing to control for risk. For investment-grade bonds, interest rate risk plays a critical role in generating returns. Because of this, the risk-adjusted income score seeks to control for the amount of interest rate risk. For high-yield bonds, the focus is on the credit risk and recovery value (in the case of default). At the end of the day, we don’t necessarily want to own only bonds with seemingly attractive spreads. By qualifying spreads by the risks they entail, we are attempting to avoid investing in bonds that are trading cheap for a reason. Next, income scores of all the bonds are ranked against sector peers to establish a percentile ranking from 0% to 100%. Top bonds are ranked closer to 100, average bonds near 50 and lower-scoring bonds near zero. Therefore, if we multiply the bonds’ rank by 2, average bonds (50th percentile) receive no additional weight. Bonds with high income scores will receive a greater weight, and low-income-score bonds see their weight reduced⁵. Investors can think about this process as attempting to add incremental income via spread while qualifying that incremental spread to a unit of risk. Ultimately, the goal of this tilt is to increase the income return potential of the Index while retaining quality from the fundamental cut. Below, we show a hypothetical application of the income score adjustment process.   Figure 2: Hypothetical Income Score Application Ultimately, our approach of tilting toward income seeks to close the deficit in yield by increasing weights to quality bonds in a thoughtful way. While quality will not always outperform, we believe that our fundamental approach to fixed income could add value over market cycles. By adjusting the final weights of the Index with a focus on risk-adjusted yield, we seek to bring the income characteristics of our approaches back in line with market-capitalization weighted strategies.         ¹Compared to the BofA Merrill Lynch U.S. Corporate Index and the BofA Merrill Lynch U.S. High Yield Index. ²Source: BofA Merrill Lynch, as of 3/31/16. ³Source: WisdomTree, as of 3/31/16. ⁴An interest rate risk adjustment is applied to only investment-grade strategies due to the greater sensitivity of that market to changes in nominal interest rates. ⁵The final Index weights are scaled proportionally to add up to 100%.