Putting Credit Factor Investing into Practice

Abstract

Implementing established corporate bond factors in real-world portfolios poses many challenges for investors. Firstly, the investment universe is reduced by non-tradable assets. We avoid investing into these bonds by constructing a tradability measure based on past transaction data. A realistic strategy to implement should target bonds that are being traded in the market. Secondly, factor performance is typically measured against a benchmark. To allow for a fair comparison, we limit the deviation between portfolio and benchmark in key dimensions. Consequently, not only bonds with the best signals can be included in the portfolio. Overall, this reduced universe paired with other restrictions and higher transaction costs than on the equity side leads to a substantial performance decrease. Nevertheless, we show that factor investing in credit is still a successful strategy if it is approached with realistic expectations and common pitfalls are avoided. Our enhanced approach translates signals into usable trading strategies, outperforming the benchmark with an information ratio of 1.1 (1.4) for investment grade (high yield).

Keywords: Cross-sectional Asset Pricing, Corporate Bonds, Factor Investing, Portfolio Construction

JEL Classification: G11, G12, G14