Why fixed income target exposure strategies can yield out-performance

• The Target Yield strategy features target exposure model in fixed income, which allows investors to achieve higher yield without bearing additional risk from credit rating or duration. 
• The strategy has similar effect from the fixed income Value factor, where we can profit from overweighing the relatively cheaper bonds.
• It serves as an alternative fixed-income solution that delivers constant yield uplift, and potentially provides excess return under most market conditions. 

Capturing yield has been crucial for fixed-income investors as yield indicates the expected return. However, higher yield does not come free of charge. It is often accompanied by higher risks of interest rate movements, liquidity, and companies’ credit conditions, to name a few. We all strive to reach a balance between enjoying benefits from higher yield and bearing too much risk.

Here we explore a Target Yield strategy on fixed-income credit indices, with the aim of enhancing yield of the index and potentially improving the performance. To avoid unnecessary exposure to risks from interest rate and credit quality, we incorporate control over index-level duration and rating. In addition, we apply caps on industry movements and issuer weights to further reduce turnover and concentration risk. The targets and constraints, as listed below, can be achieved through our Target Exposure index construction framework.

Index Target: 10% enhancement of Yield-to-Maturity versus the base index 

Index Constraints:

1. Neutral on index-level rating and effective duration
2. Industry weight change capped at ±5% versus the base index
3. Issuer weight change capped at 10 times the base index; issuer weight capped at 5%

In our analysis, we apply the Target Yield strategy on our US Credit Index – the FTSE US Broad Investment-Grade Corporate Bond Index (USBIG Corp), targeting a 10% yield improvement against the underlying benchmark. As the index overall yield surges to around 6% in recent months, such Target Yield approach would lead to around 60 bps of yield increase compared to the benchmark (as of September 2023).

We are interested in the performance of the Target Yield strategy under different market conditions, including rising interest rate, falling interest rate, and high inflation. See Figure 2 for historical interest rates and Consumer Price Index (CPI) of the United States.

As shown in Figure 3, the Target Yield index results in highest excess return (accumulative return of 3.6% vs. 1.1% of benchmark) under the current environment where the yield of the underlying universe reaches a 10-year high. In scenarios where high inflation potentially affects the bonds’ real yield (i.e., yield adjusted for inflation), the yield enhancement helps compensate for the adjustment, and excess return persists (accumulative return of -11.9% vs. -13.8%). 

A concern of the strategy is that pursuing yield may lead to under-performance during stressed market conditions, such as the Covid-19 outbreak period in early 2020. Corporate credit bond spreads surged in response to the economic disruption, which can be observed in Figure 1. As Target Yield overweighs bonds with relatively higher yield, which also have higher spreads that imply higher credit risk, the strategy could be vulnerable to stressed market conditions. Thus, we observe a more significant drawdown of the Target Yield index compared to its benchmark (accumulative return of -3.7% vs. -2.3%).

Similarly, widening credit spreads also lead to under-performance of the Target Yield strategy versus its benchmark in 2015 (accumulative return of -1.8% vs. -0.8%, see Figure 4), mostly due to under-performance of the Energy and Manufacturing sectors which are overweighted by the strategy during the period. The two sectors were hit by drop in oil and commodity prices and showed large increase in credit spreads.

Our back-test results over the last 12 years indicate an overall out-performance against the benchmark, with an excess return of 76 bps. Annualised turnover of the Target Yield index and base index is 111% and 22%, respectively . Considering the average cost for US investment-grade corporate bond transactions, excess return persists. For example, if we assume a 30 bps of average bid-ask spread, the excess return will be reduced by 27 bps due to the additional turnover. The theoretical breakeven transaction cost will be 85 bps, which is approximately the level seen in mid-March 2020 (Covid-19 crisis). 

Figure 4 shows the annual total return differences, from which we can see that the strategy outperforms its benchmark in almost all years except for 2015 and 2020, when the market conditions are not favorable.

The excess returns come from both income and capital gain. As shown in Figure 5, there is consistent uplift in income return throughout back-test period, while the gain in principal return depends on market conditions. Due to the scale of the two returns, the total return is mainly driven by the principal return. While enhancing income return does not guarantee out-performance, it can provide an additional cushion against slightly unfavorable condition.

The potential capital gain is driven by the Value factor. In our previous research on the fixed-income Value effect , Value is defined as the “relatively cheapness” of a bond among its peers. An OAS regression model is built to determine a bond’s required compensation, considering its credit rating, maturity, and industry. Value is then calculated as the difference between OAS and fitted OAS from regression. A higher Value indicates that the bond is cheaper than its peers.

We observe that the Target Yield strategy and the Value factor both allocate more weights to cheaper bonds. To illustrate the effect, we create 10 equally weighted deciles based on bonds’ Value factor ranking, where decile 1 to 10 represents bonds from highest to lowest Value factors. Figure 6 demonstrates weight change of each decile after applying the Target Yield strategy on USBIG Corp. The top two deciles see overweight while the bottom deciles are underweighted, which suggests that Target Yield allocates more weights to the bonds with higher Value factor.

In summary, the Target Yield strategy can serve as a fixed-income index solution that delivers a constant yield uplift on top of the benchmark, without adding unnecessary risks from duration and credit rating. The most straightforward advantage of the approach is the higher expected return, which can benefit held-to-maturity investment. It is also a scheme to provide some protection against rising inflation, where the real yields might be eroded by the inflationary environment. As the target yield methodology ensures an overall yield uplift versus the benchmark, investors are in a better position to gain a relatively higher real yield and thus the inflation risk can be compensated.

The strategy also provides potential excess return which comes from both capital gain and income return. Our analysis indicates that the scheme shows substantial exposure in the Value factor, and investors can profit from purchasing the relatively cheaper bonds. Although due to the cyclical nature of the factor, Value tends to perform worse when the market environment becomes less desirable, Target Yield strategy ensures consistent excess return from the income component, and thus the overall performance can still beat the benchmark under most of the market conditions. 

Other potential drawbacks of the strategy include higher turnover and issuer concentrations. Additional studies will cover analysis on turnover, diversification, and scenario tests on interest rate environment, featuring different FTSE fixed income corporate universes to formulate new index products.