Quant-Driven Approach to Bond Selection for Your Core

Over the past 15 years, as the U.S. government has issued more and more debt, U.S. Treasury bonds have comprised an increasingly larger share of the broad U.S. investment grade bond market. In addition, the effective duration has increased as a result of both declining interest rates and increased issuance of longer dated bonds to take advantage of lower funding costs.

Core Bonds Have Become More Rate Sensitive

Source: ICE Data Indices, as of 11/18/2020. Core Bonds is represented by the ICE BofA US Broad Index. Sovereign % represents the portion of the ICE BofA US Broad Index that is comprised of U.S. Treasury Securities.

This suggests that investors who gain long-term exposure to investment grade bonds through a core bond strategy, perhaps within a typical 60/40 allocation, have a more interest rate sensitive exposure than they did previously. With rates expected to remain extremely low for the foreseeable future, income oriented investors need solutions that provide higher yield potential.

Many have looked outside the core for this, adding exposure to asset classes such as high yield bonds, emerging markets bonds, bank loans and even equity income solutions. These can all be attractive solutions, but they incorporate additional risk into an overall portfolio. Many investors may not want this level of risk within the core portion of their bond portfolio, as it is meant to produce income while also preserving capital and acting as a “ballast” against their equity exposure.

Within the core, we believe that increasing exposure to investment grade credit may be attractive, but that investors should incorporate value and quality into their selection process rather than gaining exposure through a broad-based strategy. By doing so, investors can maintain an attractive yield within their core bond exposure, without having to go further out on the risk curve. Given the increased rate sensitivity of core bonds over the past 15 years, as evidenced by the higher duration, exposure to credit is also attractive as a diversifier. Credit spreads and interest rates tend to move inversely to one another. Accordingly, we believe a strategy that selects bonds with the most attractive valuations relative to their risk may be well-suited for a core, income-oriented portfolio.

Our approach uses inputs from Moody’s Analytics^® industry-leading credit model CreditEdge^®, which is driven by an extensive dataset and decades of research. Hundreds of the world’s largest institutional investors rely upon it for credit risk management. The Moody’s Analytics model is used in our strategy to determine the “Expected Default Frequency^TM” (EDF), which is a market-based forward-looking measure of expected default risk. It is driven by three key drivers: the value of a company’s assets and liabilities, asset volatility and the point of default. A firm’s equity price is a key input to value a company’s assets, which can then be compared to the book value of its liabilities as a first step in assessing default risk. As a result, EDF and associated risk measures are updated daily as a company’s stock price changes, giving a more real time assessment of a company’s financial leverage. In simple terms, the closer a company is to its default point (when its market value of assets would be less than the book value of its liabilities) and the higher its asset volatility, the higher its risk of default and the more spread its bonds should pay as compensation.

The MVIS Moody’s Analytics US Investment Grade Corporate Bond Index and the MVIS Moody’s Analytics US BBB Corporate Bond Index track bonds within the investment grade and BBB-rated universe, respectively, that have the most attractive valuations as selected based on their methodologies. These strategies seek to outperform their broad market benchmarks by only selecting bonds that have the highest excess spread relative to their embedded risk, using inputs from proprietary credit risk metrics developed by Moody’s Analytics, representing potential upside. Ultimately, these strategies provide investment grade bond exposure and can therefore fit within a core bond portfolio, providing income potential without adding significant risk.

For an in-depth look at our approach to selecting investment grade bonds with the highest excess spread relative to their fair value, download our whitepaper.