Bond ETF investors face increased challenges in a changing interest rate environment and should consider a smarter way to get core fixed income exposure.

On the recent webcast, Bringing Factor Investing to High-Quality Core Bonds, Josh Rogers, Executive Director, Investment Beta Specialist for J.P. Morgan Asset Management, and Jack Manley, Vice President, Global Market Strategist at J.P. Morgan Asset Management, outlined a way for bond investors to adapt to a changing landscape after a three-decade long bull run in the fixed-income space and recent volatility in equity markets.

The strategists helped illustrate the current market environment where the U.S. economy won’t stall but continues to expand at a slower pace. Meanwhile, stock prices are trading at a modest premium to their historical averages, with the current S&P 500 forward price-to-earnings ratio at 16.9x, compared to its long-term average of 16.2x. At the same time, earnings growth has also slowed as the U.S. heads toward the later stages of the economic cycle.

Given the backdrop of slowing growth and increased risks toward the end of a normal business cycle, the J.P. Morgan strategists argued that bond investors should not rely on their passive investment vehicles producing the same returns as they were used to. While passive bond ETF investments provide efficiencies such as transparency, tax efficiency and low costs, the passive strategies also come with debt weightings that lack intuition. Passive bond funds are cap-weighted where the most indebted issuers have a larger weight, which may potentially expose investors to issuer solvency and valuation risks.

However, the fixed-income investment industry is following in the footsteps of the equity side as more money managers incorporate factor-based investment strategies common in equities to fixed-income funds. J.P. Morgan’s unique quantitative research has demonstrated that the same factors that have the potential to add value in equities and alternatives, can also add value in fixed income.

Specifically, the J.P. Morgan strategists highlighted three factors that can be applied to the investment-grade credit markets, including quality, value and momentum.

Quality or companies with strong fundamentals tend to outperform partially due to leverage aversion, funding constraints and the lottery ticket effect. The quality factor can be applied by screening for attributes like profitability, market leverage and coverage ratio. The resulting bond portfolio would show that higher quality companies have lower levels of risk than lower quality companies, resulting in better risk-adjusted returns.

Value or companies that are under-priced relative to their fundamentals also tend to outperform due to over-extrapolation of growth trends and/or greater default risks. The factor screens for market measure of value or spread relative to a fundamental measure of value or default risk or debt-to-earnings ratio. J.P. Morgan has found that higher value companies tend to generate higher returns and Sharpe Ratios than lower value companies, though we do see higher risk associated with higher returns.

Lastly, momentum or securities with positive recent performance continue to outperform due to behavioral bias and structural distinction between investment grade and high yield investors. The momentum factor can be screened through credit momentum or equity momentum. The strategists found that within both Credit and Equity momentum, there is an increase in returns alongside a decrease in risk as we move along quintiles, with similar results from the composite approach.

Focusing on a single factor may also expose investors to factor-specific risks. For example, a single-factor quality strategy tends to have a lower yield, turnover of a single-factor value strategy can be high and turnover of a single-factor momentum strategy can also be high.

This is where investors may utilize an integrated multi-factor approach that uses an average scoring screen across quality, value and momentum percentile ranks to craft a diversified factor-based portfolio. Employing a multi-factor approach can help limit turnover to a manageable level while also addressing challenges such as liquidity and yield that present themselves in the standalone factors.

ETF investors can also gain exposure to a multi-factor approach to bond investing through smart beta ETF strategies, such as the JP Morgan US Aggregate Bond ETF (NYSEArca: JAGG). JAGG holds a diversified portfolio of high-quality fixed income securities, including corporate bonds, U.S. Treasuries and government and agency securities. Unlike the traditional market cap-weighted bond index funds, the ETF applies a multi-factor credit screening process that seeks exposure to corporate debt issuers with attractive value, quality and momentum characteristics.

Financial advisors who are interested in learning more about core fixed-income exposures can watch the webcast here on demand.