Bond Study Confirms Investment Approach and Offers New Insight

February 11, 2020

At Dimensional, we have used a systematic approach to pursue higher expected returns in fixed income since 1983. Just like in equities, we use information in current market prices to identify differences in expected bond returns.

There is abundant academic scholarship that supports this systematic approach to fixed income. A new study as part of continuing research from Dimensional supports it, too, and identifies an additional metric—a bond issuer’s stock returns—that holds merit in evaluating fixed-income investments.

SEPARATING THE WHEAT FROM THE CHAFF

Our latest research comes amid a proliferation of variables that other researchers and investors have highlighted as having the potential to become “factors” driving a systematic investment approach in fixed income. Dimensional, on the other hand, has long focused on forward rates. We use these rates, which are calculated from current market prices, to identify differences in bonds’ expected returns.

Information in forward rates has been studied for decades, with pioneering work conducted by Professor Eugene Fama in the 1970s and 1980s, and it has been incorporated into Dimensional’s strategies for more than 35 years. The new study that is part of our ongoing research further validates this approach. The study looks at the performance of more than 7,000 US dollar-denominated corporate bonds over nearly 20 years. Our sample includes both investment grade and high yield bonds with credit ratings ranging from AAA to B. We test 14 variables to see whether they contain information about future bond returns.

Forward rates stand out in this research as the most reliable and the most useful metric for targeting bonds with higher expected returns. Using forward rates to identify bonds with lower prices (higher yields) and greater expected capital appreciation is the cornerstone of Dimensional’s approach to value investing in fixed income, and our research confirms this. Interestingly, our recent study finds that another measure of value, default-adjusted credit spreads—which look at a bond’s credit spread relative to the issuer’s chances of default—does not add information over what is already contained in forward rates.

Our study also offers valuable context in evaluating many other variables for their potential usefulness to fixed income investors. It tells us that many of the metrics that have been cited by others as predictive of expected bond returns aren’t telling us much new. Many variables are not reliably linked to expected bond returns, or they provide information about expected bond returns only through their correlation with forward rates. Our research indicates that forward rates tell you—almost—everything you may want to know about corporate bond returns.

FINDING INSIGHT IN STOCK RETURNS

The one metric among the many we examined that has information complementing what forward rates tell us about expected returns is the recent performance of a bond issuer’s stock. If a company’s stock underperforms the market in a given month, our findings show that its bonds tend to underperform in the next month. Short-term equity returns show little correlation to forward rates.

Short-term equity returns aren’t a new area of interest at Dimensional. We have for many years evaluated a bond issuer’s recent stock performance as part of our trading and credit monitoring approach in fixed income, which uses up-to-date information from many sources, including credit rating agencies, trade prices and quotes, credit default swaps, and reviews of any related news. Our new study contributes to our understanding of the relationship between short-term equity returns and expected bond returns.

Click here to read on.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.