At Dimensional, we have used a systematic approach to pursue higher expected returns in fixed income since 1983. Just like in equities, we use information in current market prices to identify differences in expected bond returns.
There is abundant academic scholarship that supports this systematic approach to fixed income. A new study as part of continuing research from Dimensional supports it, too, and identifies an additional metric—a bond issuer’s stock returns—that holds merit in evaluating fixed income investments.
Our latest research comes amid a proliferation of variables that other researchers and investors have highlighted as having the potential to become “factors” driving a systematic investment approach in fixed income. Dimensional, on the other hand, has long focused on forward rates. We use these rates, which are calculated from current market prices, to identify differences in bonds’ expected returns.
Information in forward rates has been studied for decades, with pioneering work conducted by Professor Eugene Fama in the 1970s and 1980s, and it has been incorporated into Dimensional’s strategies for more than 35 years. The new study that is part of our ongoing research further validates this approach. The study looks at the performance of more than 7,000 US dollar-denominated corporate bonds over nearly 20 years. Our sample includes both investment grade and high yield bonds with credit ratings ranging from AAA to B. We test 14 variables to see whether they contain information about future bond returns.
Forward rates stand out in this research as the most reliable and the most useful metric for targeting bonds with higher expected returns. Using forward rates to identify bonds with lower prices (higher yields) and greater expected capital appreciation is the cornerstone of Dimensional’s approach to value investing in fixed income, and our research confirms this. Interestingly, our recent study finds that another measure of value, default-adjusted credit spreads—which look at a bond’s credit spread relative to the issuer’s chances of default—does not add information over what is already contained in forward rates.
Our study also offers valuable context in evaluating many other variables for their potential usefulness to fixed income investors. It tells us that many of the metrics that have been cited by others as predictive of expected bond returns aren’t telling us much new. Many variables are not reliably linked to expected bond returns, or they provide information about expected bond returns only through their correlation with forward rates. Our research indicates that forward rates tell you—almost—everything you may want to know about corporate bond returns.
Finding Insight in Stock Returns
The one metric among the many we examined that has information complementing what forward rates tell us about expected returns is the recent performance of a bond issuer’s stock. If a company’s stock underperforms the market in a given month, our findings show that its bonds tend to underperform in the next month. Short-term equity returns show little correlation to forward rates.
Short-term equity returns aren’t a new area of interest at Dimensional. We have for many years evaluated a bond issuer’s recent stock performance as part of our trading and credit monitoring approach in fixed income, which uses up-to-date information from many sources, including credit rating agencies, trade prices and quotes, credit default swaps, and reviews of any related news. Our new study contributes to our understanding of the relationship between short-term equity returns and expected bond returns.
While short-term equity returns provide insight into expected bond returns, our research shows this insight to be somewhat ephemeral—its short-term nature means using it in isolation to drive trading decisions could lead to high, and potentially costly, turnover for investors. This is why we use short-term equity returns to complement our trading decisions, helping to inform the overall merits of a potential “buy” or “sell” order alongside a host of other considerations that are evaluated as part of our process of executing a trade. Consistent with existing research and our fresh examination of credit variables’ potential relation to bond returns, forward rates are the key metric Dimensional uses to pursue higher expected returns in fixed income.
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
Eugene Fama is a member of the Board of Directors of the general partner of, and provides consulting services to, Dimensional Fund Advisors LP.
This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, call risk, and other factors. Inflation-protected securities may react differently from other debt securities to changes in interest rates.