When you think about a smart beta investment strategy, you probably think about equities. Many investors have become familiar with the notion of capturing historically rewarded factors, such as value, quality, or low volatility, in their stock portfolios. In essence, smart beta strategies seek to re-write index rules to capture these factors. What some investors may not know is that this way of thinking can be applied to bond portfolios. How? Let’s take a look at the market dynamics in fixed income.

Different risk profiles

The first thing to keep in mind is that the nature of fixed income makes the return payout asymmetrical. The best a bond can do is pay its coupons and return its par value; however the worst it can do is default and leave you with $0. As a result a lot of the value that can be generated in fixed income is about loss avoidance, and about managing risk over time.

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Equity markets are predominately characterized by stock specific risk. For example, you will likely have a very different return experience investing in Citigroup versus Apple. In contrast, fixed income markets have far less security-specific risk. In fact, the total return for core bond portfolios is governed predominately by exposures to two macro-economic risk factors: interest rate risk and credit risk. As my colleague Matt Tucker wrote in a recent post, core fixed income benchmarks like the Barclays US Aggregate are dominated by interest rate risk, and in the current market environment, investors are not paid very much to take on that risk.

But how should an investor manage these macro-economic exposures in their bond portfolio? The allocation decision between interest rate and credit exposure will have a significantly larger impact on the investment outcome than would any security-specific decisions. BlackRock’s first fixed income smart beta ETF, iShares US Fixed Income Balanced Risk (INC), factors in this dynamic and seeks to generate income through a diversified portfolio that balances the primary components of returns – interest rate and credit risk.

Investor behavior creates opportunity

When it comes to both stocks and bonds, market inefficiencies can be driven by powerful forces like investor behavior and structural impediments. Some of these phenomena are similar across equities and fixed income: many investors are averse to leverage and therefore gravitate to riskier stocks in their search for high returns, which can lead to over-buying of higher volatility stocks.*. That same leverage aversion exists among fixed income investors – longer duration bonds may be over-priced on a risk-adjusted basis compared to similar bonds of a shorter maturity (Barclays). Other inefficiencies are unique to bond markets: commonly used benchmarks like the Barclays Aggregate only include investment grade securities, and as a result some investors add exposure to sectors such as high yield or emerging market debt to help boost yield.

All of the above phenomena are well known by fixed income managers (and have been the fodder of active fixed income strategies for decades) but have not been arbitraged away precisely because of the barriers presented by these behavioral or structural market forces. Fixed income smart beta funds, such as INC, seek to capture these inefficiencies in a rules based and transparent manner.

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