Diversifying styles to survive today’s bond market

Thus far in 2022, outright exposure to two primary fixed income risk factors — duration and credit spreads — has proved challenging. As a result, investors are increasingly seeking innovative and differentiated ways to protect their bond portfolios amid unprecedented market volatility.

Interestingly, from our fundamental factor-based perspective, there has been a consistent bright spot across global government bond and corporate credit markets: Momentum has proven to be a highly diversifying exposure on a year-to-date basis, which we think speaks to the persistence of the market environment during the first half of the year. In this brief note, we’ll focus on global government bonds, though we’ve seen comparable results for momentum in corporate credit. 

Momentum’s performance in perspective

In our framework, momentum within global government bond markets has been among the best-performing factors this year, in both absolute and risk-adjusted terms. In fact, the magnitude of the outperformance has reached historic proportions, with 2022 on pace to be a record year for the style in the post-GFC era.

In Figure 1, we highlight the year-to-date performance of our proprietary Rates Momentum factor through September 30. The factor returned nearly 6% while the broader global government bond market realized double-digit negative total returns.

Looking at bond markets through a factor lens

How is this different from just highlighting an underweight to duration risk? It is true that recently momentum has generally been underweight most global government bond markets. However, in previous periods of heightened market volatility, such as the early days of the COVID-19 pandemic (March 2020), this style has shown the potential to provide downside protection to risk assets such as equities and credit. In these prior events, we observed momentum as being overweight duration risk at select sovereign curve points, which makes sense given the declining interest-rate trend at the time.

We believe a key benefit of utilizing a style-oriented fundamental factor framework is that it follows a rules-based process of naturally sorting through the market opportunity set. This may provide the potential for a more dynamic active risk profile, offering allocators an alternative solution that is less reliant on static traditional beta exposures.

Investment implications

• Many fixed income allocators structure their portfolios around traditional risk factors such as interest-rate and credit sensitivity. While that is a completely reasonable starting point, we think style factors are an overlooked area that may help deliver improved portfolio outcomes, particularly as we continue to operate in an uncharted market environment that has thus far left traditional fixed income risk factors unable to deliver on their intended roles.
• Despite the strong results of late, we believe exposure to momentum and other factors in the Trend Following category can continue to serve a valuable core role in portfolios, given their potential diversification and downside protection properties. Exposure to this style should be weighed alongside other nuanced fixed income investment styles such as Mean Reversion, Risk Aversion, and Carry, depending on overall portfolio objectives.