EDHEC-Risk Institute has conducted two new studies, commissioned by ETF issuer Amundi, that investigate the theoretical and practical challenges involved in harvesting risk premia in fixed income markets.

Bruno Taillardat, Head of Smart Beta & Factor Investing at Amundi.

The studies focus on two factors that explain a large fraction of differences in the cross-section of bond returns, namely “value” and “momentum”, using economically justified proxies for these attributes.

Riccardo Rebonato, Professor of Finance at EDHEC-Risk Institute, EDHEC Business School, said, “Return predictability in the Treasury bond market is currently one of the most exciting areas for smart beta investment.

“The papers are two contributions in a much wider research programme at EDHEC, focused on the cross-sectional and time series predictability in the fixed income space.”

Smart beta has experienced robust growth within the ETF industry in recent years. According to ETF industry consultants ETFGI, investors ploughed $77.6 billion into smart beta ETFs globally in 2018, bringing total assets under management within the genre to $618bn.

While equity products have traditionally driven the growth of smart beta ETFs, fixed income is playing an increasingly influential role. A recent report from BlackRock, which predicts global fixed income ETF AUM to double to $2trn by 2024, identified innovation in factor-based fixed income strategies as a theme driving the growth trajectory higher.

Bruno Taillardat, Head of Smart Beta & Factor Investing at Amundi, said, “The increasing adoption of smart beta and factor-based solutions, particularly in the area of fixed income investment, represents an exciting challenge for asset managers seeking to design the right solutions to address clients’ needs. To further enhance Amundi’s strong engagement to helping investors meet their asset allocation goals, our partnership with the EDHEC-Risk Institute is a key element to strengthen our leadership in providing education and research tools.”

Value

The first paper, entitled “Factor Investing in Fixed-Income – Defining and Exploiting Value in Sovereign Bond Markets”, examines the difference in the market price of Treasury bonds compared to their theoretical price between 1975 and 2017.

The theoretical price for Treasury bonds is determined using a Gaussian term structure model that is calibrated to be economically relevant and tested to be financially sound.

The paper then proposes a ‘value factor’ strategy that entails buying Treasury bonds that are trading significantly below their theoretical price and shorting Treasury bonds that are trading significantly above their theoretical price.

EDHEC reports that the strategy produces a strongly positive Sharpe ratio. Indeed, the results are so robust that, before and after adjusting for duration exposure, the strategy produces a positive Sharpe ratio which is statistically significantly different from zero at the 99.9% confidence level in 13 of the three-year sub-periods out of 15 between 1975 and 2017, and an average Sharpe ratio (before transaction costs) above 1.

Momentum

The second paper, entitled “Factor Investing in Fixed-Income – Cross-Sectional and Time-Series Momentum in Sovereign Bond Markets”, undertakes a systematic, security-level analysis of momentum and reversal strategies in US Treasuries, covering more than 40 years of data.

The research found that both momentum and reversal strategies produce positive Sharpe ratios that are statistically and economically significant.

Additionally, after adjusting for duration, the reversal cross-sectional strategy has an even larger Sharpe ratio and is profitable over a wider range of investment periods. The paper proposes an explanation for this finding in the mean-reverting properties of the yield curve slope.