What are the factors to consider while investing in bonds?

Investing has evolved a lot in the last decade. Recent research has helped investors to identify various factors that are associated with a stock, which helps it to outperform or underperform a benchmark in different market conditions. Factors are the building blocks of investing. A better understanding of the factors will help investors to make a more informed decision. Considering a few factors while investing can help one to earn better returns, minimise the risk and diversify portfolio based on their risk profile. Factor-based investing is also known as a smart beta strategy by many.  The AUM for factor-based strategies is currently estimated at approx. USD 2 trillion and is expected to cross USD 3.4 trillion by the end of 2022.

Factors in bonds

Currently, there are more than 250 types of factors identified in equity investing. Some of the most popular equity factors are size, value, quality, growth and momentum.  Even in fixed income space, many factors such as size, quality, value and momentum are adopted from equity.  In the case of bonds, there are broadly two types of papers-one is corporate bonds and the other is government bonds.

Value: Under this bond, trading becomes cheaper than their fair value or relative value to similar funds and may generate better returns in the long-run.

Quality: In the case of government bonds, the health of an economy is observed based on its finances such as current account deficit, fiscal deficit etc to identify the quality of the paper. Similarly, for corporate bonds, the credit quality of the companies is assessed based on its finance and creditworthiness. Funds with larger exposure to such bonds are expected to do better.

Size: For government bonds, large economies with lower debt to GDP ratio, is a good size factor. Small bond issues or issuers are likely to generate better returns.

Low Volatility: In the case of government bonds, a combination of duration and yield to maturity measures the volatility of the bonds. Whereas, in the case of corporate bonds, the duration and credit spread measures the volatility. Again, lower value means lower volatility and hence, better performance.