Factor Exposure: A Fresh Way to Diversify Corporate Bond Portfolios
Pension funds, private banks, insurers and other institutional investors may achieve better risk management and more resilient performance from diversified sources of alpha.
Key Takeaways
Factor diversification adds multiple return drivers that may complement holdings diversification in high-yield corporate bond portfolios.
Multifactor approaches may reduce tracking error and drawdowns while supporting more concentrated, implementation-aware credit portfolios.
Combining carry, value, momentum, quality and more can help address systematic risk drivers that dominate high-yield market outcomes.
Why Traditional Diversification May Miss Systematic Credit Risk
Conventional wisdom suggests that spreading investments across many securities reduces idiosyncratic (asset-specific) risk. But, if all the securities share similar characteristics, are the actual diversification benefits significant?
For institutional investors, adding multifactor exposure to diversified high-yield corporate bond portfolios may lift performance potential while mitigating risk.
We’ve examined how allocation across multiple active return sources — carry, value, momentum, quality, low volatility and size — interacts with conventional diversification strategies.
What Our Research Suggests About Factor Diversification
Our research indicates that adding factor diversification to a traditional holdings-focused diversification strategy may:
Improve performance potential.
Reduce risk more efficiently.
Create portfolios better suited to real-world trading conditions.
How Factor Exposure May Complement High-Yield Bond Diversification
Our upcoming Journal of Fixed Income paper provides a detailed analysis. In the meantime, here are five potential benefits:
1. Risk Reduction Without a Larger Portfolio
Traditional diversification requires owning many securities to reduce risk. Factor diversification offers another approach by:
Potentially reducing tracking error as much as or more than increasing the number of holdings.
Maintaining a more concentrated, efficient portfolio.
Addressing key challenges of the high-yield market, including trading costs and liquidity constraints.
2. Stronger Drawdown Protection
Our research shows that:
Multifactor portfolios have experienced smaller drawdowns than single-factor or lightly diversified portfolios.
Factor diversification helps to mitigate the systematic drivers of high-yield drawdowns.
Each factor responds differently to market stress, so combining factors may help cushion losses.
3. Higher, More Durable Information Ratios
Multifactor construction has the potential to improve information ratios across most levels of portfolio concentration significantly. Here’s why:
Each factor adds an independent source of return.
The combined factor signal is generally more stable and more predictive than any single component.
Factor diversification helps reduce volatility in the pursuit of active returns.
Our research suggests investors may gain greater confidence in alpha persistence, greater efficiency in active risk budgeting and better long‑run compounding of excess returns.
4. Aligned with Real-World Trading Conditions
The lower liquidity, higher transaction costs and event-driven risks associated with high-yield bonds can be costly and challenging. Factor diversification can help by:
Reducing reliance on large portfolios that are costly to trade.
Focusing on persistent, economically grounded drivers of return potential.
Fostering concentrated, risk-controlled portfolios that may be easier to execute.
Along with improving scalability and capacity management, factor diversification also seeks to deliver more consistent alpha in the higher-risk, high-yield market.
5. Targeted Risk Management
Corporate bond portfolios generally face two types of risk:
Asset-specific, which traditional diversification addresses.
Systematic, the dominant risk driver, which factor diversification combats.
Incorporating both types of diversification may help institutional investors:
Draw on research-based insights regarding risk and return.
Allocate risk exposure and return drivers more precisely.
Maintain greater control over performance outcomes.
An Efficient Approach to High-Yield Credit
For institutional investors seeking robust risk-adjusted performance from high-yield bonds, traditional diversification may not be enough.
We believe incorporating diverse factor exposure provides a compelling alternative, enhancing traditional diversification to pursue better risk management and more resilient performance.
We look forward to sharing our upcoming paper, “The Comparative Advantages of Factor Diversification versus Holding Diversification in Actively Managed High-Yield Bond Portfolios.” It highlights the complementary — yet distinct — roles of diversification among holdings and factors.
Authors
Vice President, Senior Portfolio Manager
Head of Systematic Credit, Global Fixed Income
Mindset Built for Opportunity
We aim to provide the diversity, steady income and risk management that asset allocators seek from their fixed-income portfolios.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.