Factor Based Investing and Corporate Bonds?

Philipp Meyer-Brauns, PhD

Vice President and Senior Researcher

Joseph Kolerich
Head of Fixed Income, Americas

March 12, 2020

FOR PROFESSIONAL USE ONLY. NOT FOR USE WITH RETAIL INVESTORS OR THE PUBLIC
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 Components of a Bond Return

The current yield

curve provides
1 information about
two of the
2 components of
+ 1 Yield: Known, observable expected return.
3
_
Yield

2 Term: Known, observable

3 Future Change in Yield:

Not known, not observable
Expected return = 0
4Y 5Y
Maturity (years)

For Illustrative Purposes Only.

MKT3468-0319
 Alternative Variables and Expected Bond Returns
Overview

Bond-level Characteristics
Forward Rate Forward Rate of the corporate bond

Default-Adj Credit Spread (“Value”) Residual from monthly cross-sectional regressions of credit spread on distance to default

Short-Term Bond Return Total bond return over the past month

Bond Momentum Total bond return over the past six months, excluding the most recent month

Short-Term Credit Premium Bond return in excess of matching Treasury over the past month

Credit Momentum Bond return in excess of matching Treasury over the past six months, excluding the most recent month

#66464-0918
 Alternative Variables and Expected Bond Returns
Overview

Issuer-level Characteristics
Market Capitalization Issuer equity market capitalization

Total Public Debt Outstanding Total market value of bonds issued by a bond’s issuer

Book-to-Market Issuer ratio of book equity to market capitalization

Profitability Issuer operating income before depreciation and amortization minus interest expense divided by book equity

Leverage Issuer ratio of net debt to (net debt + equity market capitalization)

Distance to Default Model-derived measure of issuer’s default risk (Merton 1974, Bharath and Shumway 2008)

Short-Term Equity Return Issuer stock return over the past month

Equity Momentum Issuer stock return over the past six months, excluding the most recent month

Merton 1974 refers to Merton, R. C. 1974. On the Pricing of Corporate Debt: The Risk Structure of Interest Rates. Journal of Finance 29(2): 449–470
Bharath and Shumway 2008 refers to Bharath, S. and T. Shumway. 2008. Forecasting Default with the Merton Distance to Default Model. Review of Financial Studies 21(3): 1339–1369
#66464-0918
 Corporate Bond Data Overview

Monthly bond data sourced from Bloomberg Barclays US Aggregate and US High Yield Universe
• Data covers 2000–2018
• Investment Grade and High Yield (S&P Rating AAA–B)
• Duration between 1 and 10 years
• Excluding bonds with optionality (except Make Whole Call)

Monthly stock data sourced from Bloomberg Global Stock Database

• Linked to Bloomberg Global Stock Database to obtain equity characteristics of a bond’s issuer
• Restricted to mappings that ensure meaningful link between security and issuer equity characteristics
• On average, 93% of market value (90% of bond observations) can be mapped to a publicly listed entity
• Links to common stock only (excluding debt of REITs, MLPs, etc.)

Bloomberg Barclays data provided by Bloomberg. All rights reserved. Indices are not available for direct investment.
#66464-0918
Summary Statistics—Sample Overview

Average Monthly Number Unique Number

Bonds 1,492 7,240

Issuers 377 900

Source: Bond data are from Bloomberg Barclays and include constituents of the US Aggregate Index and US High Yield Bond Index. US issuers and USD-denominated debt only. The sample period is
January 2000 to December 2018. See “Corporate Bond Data Overview” for additional information on sample inclusion criteria.
 Can We Identify Differences in Returns?
Average Monthly Returns, 2000–2018

TOTAL RETURN
VARIABLE LOW 2 3 HIGH HIGH–LOW T-STAT
Forward Rate 0.31% 0.41% 0.48% 0.59% 0.28% 2.09
Market Capitalization 0.46% 0.46% 0.42% 0.45% -0.01% -0.15
Total Public Debt Outstanding 0.50% 0.44% 0.41% 0.46% -0.04% -0.55
Book-to-Market 0.46% 0.46% 0.46% 0.42% -0.04% -0.35
Profitability 0.48% 0.45% 0.42% 0.45% -0.03% -0.43
Leverage 0.45% 0.47% 0.46% 0.42% -0.03% -0.29
Distance to Default 0.45% 0.43% 0.47% 0.45% 0.00% -0.01
Default-Adj Credit Spread ("Value") 0.30% 0.41% 0.49% 0.59% 0.29% 3.13
Short-Term Equity Return 0.25% 0.44% 0.47% 0.63% 0.38% 4.51
Equity Momentum 0.35% 0.47% 0.45% 0.53% 0.17% 1.78
Short-Term Bond Return 0.42% 0.40% 0.45% 0.52% 0.11% 1.11
Bond Momentum 0.46% 0.43% 0.44% 0.47% 0.01% 0.11
Short-Term Credit Premium 0.47% 0.41% 0.44% 0.47% 0.00% 0.03
Credit Momentum 0.45% 0.42% 0.44% 0.49% 0.05% 0.39

Past performance, including hypothetical performance, is no guarantee of future results.

Filters were applied to data retroactively and with the benefit of hindsight.
Source: Bond data are from Bloomberg Barclays and include constituents of the US Aggregate Index and US High Yield Bond Index. Equity data are from Bloomberg Global Stock database and CRSP. US
issuers and USD-denominated debt only. The sample period is January 2000 to December 2018. Quartiles are market capitalization weighted and rebalanced monthly. Low, 2, 3, High represent quartile groups
of bonds resulting from a sort on the respective variables and each contain approximately 25% of total market value. See “Alternative Variables and Expected Bond Returns” for additional information on the
variables used. Groups of bonds are hypothetical, are not representative of indices, actual investments or actual strategies managed by Dimensional, and do not reflect costs and fees associated with an actual
investment. Actual investment returns may be lower.
#66464-0918
 Can We Identify Differences in Unexpected Returns?
Average Monthly Returns, 2000–2018

TOTAL RETURN – FORWARD RATE

VARIABLE LOW 2 3 HIGH HIGH–LOW T-STAT
Forward Rate – – – – – –
Market Capitalization -0.06% 0.01% 0.00% 0.05% 0.12% 1.58
Total Public Debt Outstanding 0.01% -0.01% -0.02% 0.02% 0.01% 0.09
Book-to-Market 0.05% 0.03% 0.01% -0.09% -0.14% -1.27
Profitability 0.00% 0.01% -0.01% 0.01% 0.01% 0.14
Leverage 0.04% 0.04% 0.00% -0.08% -0.12% -1.07
Distance to Default -0.05% -0.03% 0.04% 0.05% 0.10% 0.82
Default-Adj Credit Spread ("Value") -0.04% -0.01% 0.03% 0.01% 0.04% 0.48
Short-Term Equity Return -0.22% 0.01% 0.04% 0.17% 0.39% 4.67
Equity Momentum -0.14% 0.04% 0.02% 0.08% 0.22% 2.27
Short-Term Bond Return -0.05% -0.01% 0.03% 0.03% 0.08% 0.83
Bond Momentum 0.00% 0.02% 0.01% -0.03% -0.03% -0.23
Short-Term Credit Premium -0.02% 0.01% 0.03% -0.02% 0.00% 0.02
Credit Momentum -0.04% 0.01% 0.02% 0.00% 0.04% 0.36

Past performance, including hypothetical performance, is no guarantee of future results.

Filters were applied to data retroactively and with the benefit of hindsight.
Source: Bond data are from Bloomberg Barclays and include constituents of the US Aggregate Index and US High Yield Bond Index. Equity data are from Bloomberg Global Stock database and CRSP. US
issuers and USD-denominated debt only. The monthly returns reported are average monthly corporate bond returns minus a bond's forward rate at the beginning of the month. The sample period is January
2000 to December 2018. Quartiles are market capitalization weighted and rebalanced monthly. Low, 2, 3, High represent quartile groups of bonds resulting from a sort on the respective variables and each
contain approximately 25% of total market value. See “Alternative Variables and Expected Bond Returns” for additional information on the variables used. Groups of bonds are hypothetical, are not
representative of indices, actual investments or actual strategies managed by Dimensional, and do not reflect costs and fees associated with an actual investment. Actual investment returns may be lower.
#66464-0918
 Summary of Regression Results
Slope Coefficients from 162 Regressions of Corporate Bond Returns on Test Variables

Total Return Reliably different from zero (|t|>2) Not reliably different from zero (|t|<2)

0.30

0.20

0.10

0.00

-0.10

Total Return minus Forward Rate

0.30

0.20

0.10

0.00

-0.10
Forward Market Total Public Book-to- Profitability Leverage Distance to Default-Adj Short-Term Equity Short-Term Bond Short-Term Credit
Rate Capitalization Debt Market Default Credit Spread Equity Return Momentum Bond Return Momentum Credit Momentum
Outstanding (“Value”) Premium

This figure shows the regression coefficients from 162 univariate regressions of corporate bond returns on our test variables. Test variables are normalized each month by dividing each observation by the
variable’s cross-sectional standard deviation. The top chart shows regression results when the independent variable is a bond’s unadjusted total return. The bottom chart shows regression results when the
independent variable is a bond’s total return minus its beginning of month forward rate. Six different regression specifications are used for each variable: Fama-MacBeth regressions on the explanatory
variable, Fama-MacBeth regressions on the monthly cross-sectional rank of the explanatory variable, Fama-MacBeth regressions on the monthly cross-sectional rank of the explanatory variable within its
credit rating category, panel regressions on the explanatory variable, panel regressions on the monthly cross-sectional rank of the explanatory variable, and panel regressions on the monthly cross-
sectional rank of the explanatory variable within its credit rating category. Panel regressions include monthly fixed effects and standard errors are clustered by issuer and month. See “Alternative Variables
and Expected Bond Returns” for additional information on the variables used.
MKT3468-0319
 Cross-Sectional Differences in Future Yield Changes
Monthly Fama-MacBeth Cross-Sectional Yield Predictive Regressions, 2000–2018

Yield change in month t

Coefficient t-stat R²

Forward Rate 0.00 -0.12 0.12

Short-Term Equity Return -0.05 -4.51 0.03

Past performance, including hypothetical performance, is no guarantee of future results.

Filters were applied to data retroactively and with the benefit of hindsight.
Source: Bond data are from Bloomberg Barclays and include constituents of the US Aggregate Index and US High Yield Bond Index. Equity data are from Bloomberg Global Stock database and CRSP. US
issuers and USD-denominated debt only. The sample period is January 2000 to December 2018. Test variables are normalized each month by dividing each observation by the variable’s cross-sectional
standard deviation. See “Alternative Variables and Expected Bond Returns” for additional information on the variables used.
#66464-0918
Short-Term Equity Return—Additional Analysis
Average Monthly Premium in the Months Following Portfolio Formation

0.4% High minus Market Low minus Market

0.2%
Short-Term
0.0%
Equity Return
-0.2%

-0.4%
1 2 3 4 5 6 7 8 9 10 11 12
0.4%

0.2%
Forward
0.0%
Rate
-0.2%

-0.4%
1 2 3 4 5 6 7 8 9 10 11 12

Months following portfolio formation

Past performance, including hypothetical performance, is no guarantee of future results.
Filters were applied to data retroactively and with the benefit of hindsight.
Source: Bond data are from Bloomberg Barclays and include constituents of the US Aggregate Index and US High Yield Bond Index. Equity data are from Bloomberg Global Stock database and CRSP. US
issuers and USD-denominated debt only. The sample period is January 2000 to December 2018. This figure shows the average monthly premium over the market of high short-term equity return and low short-
term equity return quartile portfolios (top chart) and of the high forward rate and low forward rate quartile portfolios (bottom chart) over the 12 months following portfolio formation. Shaded areas are two-
standard-error bands. Quartiles are market capitalization weighted, formed monthly and each contain approximately 25% of total market value at the time of formation. See “Alternative Variables and Expected
Bond Returns” for additional information on the variables used. Groups of bonds are hypothetical, are not representative of indices, actual investments or actual strategies managed by Dimensional, and do not
reflect costs and fees associated with an actual investment. Actual investment returns may be lower.
 Short-Term Equity Return—Additional Analysis
Monthly Average Return Difference Between High and Low Quartile Portfolios at Different Rebalancing Frequencies

Reliably different from zero (|t|>2)

0.40% 0.38% Not reliably different from zero (|t|<2)

0.30% 0.28%
0.26% 0.25%

0.20%
0.15%

0.10%

0.00%

-0.04%
-0.10%
Monthly Semi-annual Annual Monthly Semi-annual Annual
rebalancing rebalancing rebalancing rebalancing rebalancing rebalancing

FORWARD RATE SHORT-TERM EQUITY RETURN

Past performance, including hypothetical performance, is no guarantee of future results.

Filters were applied to data retroactively and with the benefit of hindsight.
Source: Bond data are from Bloomberg Barclays and include constituents of the US Aggregate Index and US High Yield Bond Index. Equity data are from Bloomberg Global Stock database and CRSP. US
issuers and USD-denominated debt only. The sample period is January 2000 to December 2018. Quartiles are market capitalization weighted and rebalanced monthly, semi-annually at the end of December
and at the end of June, or annually at the end of December, and each contain approximately 25% of total market value. See “Alternative Variables and Expected Bond Returns” for additional information on
the variables used. Groups of bonds are hypothetical, are not representative of indices, actual investments or actual strategies managed by Dimensional, and do not reflect costs and fees associated with an
actual investment. Actual investment returns may be lower.
#66464-0918
Our New Paper
What did we find?

• Forward rates work

This is what Dimensional uses in our implementation of value investing.

Interestingly, another measure of value, default-adjusted credit spread, did not add
information over what is already contained in forward rates.

• Short-term equity returns

If a company’s stock does poorly, its bonds tend to have relative underperformance in the
next month or two. Dimensional accounts for this systematically in our daily investment
process.

• Many other variables do not work

This includes bond momentum and other stock characteristics such as price-to-book or
profitability.

Past performance is no guarantee of future results.

Forward Rates
 Estimating Expected Returns in Fixed Income

The current yield

curve provides
information about
1 two of the
components of
expected return.
2
+ 1 Yield: Known, observable
3
_
Yield

2 Term: Known, observable

3 Future Change in Yield:

Not known, not observable
Expected return = 0
4Y 5Y
Maturity (years)
For Illustrative Purposes Only.

#MP344-0319
Treasury Expected Return Matrix

Buy Maturity

Years 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.15

4.5 1.43%

4.0 1.44% 1.40%

3.5 1.44% 1.43% 1.39%

3.0 1.43% 1.41% 1.39% 1.34%

Sell Maturity

2.5 1.41% 1.40% 1.37% 1.34% 1.29%

2.0 1.39% 1.37% 1.35% 1.32% 1.29% 1.22%

1.5 1.37% 1.36% 1.34% 1.31% 1.29% 1.26% 1.24%

1.0 1.38% 1.37% 1.35% 1.33% 1.32% 1.31% 1.33% 1.36%

0.5 1.39% 1.38% 1.37% 1.36% 1.35% 1.35% 1.38% 1.42% 1.42%

0.0 1.41% 1.40% 1.39% 1.38% 1.38% 1.39% 1.42% 1.46% 1.48% 1.52% 1.56%

For illustrative purposes only.

These expected returns are calculated by Dimensional Fund Advisors LP using yield curve data (USD) and assuming various holding periods. The input data is sourced from Bloomberg BVAL. The expected
returns are calculated as forward rates based on the Bloomberg data. There is no guarantee that any product or strategy offered by Dimensional will achieve the returns shown. Any forward-looking
statements speak only as of the date they are made, and Dimensional assumes no duty and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous
assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements.
Deconstructing a Corporate Bond

Corporate Bond = Treasury Bond + Credit Spread

Corporate Bond Expected Return

Treasury Curve Credit Curve

1t

1c
2t 2c

+ +
3c
3t _
_
+
Yield

Yield
4Y 5Y 4Y 5Y
Maturity (years) Maturity (years)
BBB Corporate Expected Return Matrix

Buy Maturity

Years 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.15

4.5 1.93%

4.0 2.35% 2.40%

3.5 2.37% 2.40% 2.03%

3.0 2.40% 2.43% 2.26% 2.16%

Sell Maturity

2.5 2.35% 2.36% 2.22% 2.16% 1.81%

2.0 2.31% 2.31% 2.20% 2.15% 1.97% 1.84%

1.5 2.28% 2.27% 2.17% 2.12% 1.99% 1.94% 1.83%

1.0 2.23% 2.22% 2.13% 2.08% 1.98% 1.94% 1.88% 1.73%

0.5 2.18% 2.17% 2.08% 2.04% 1.94% 1.90% 1.85% 1.76% 1.64%

0.0 2.15% 2.13% 2.06% 2.01% 1.93% 1.90% 1.86% 1.80% 1.76% 1.78% 1.82%

For illustrative purposes only.

These expected returns are calculated by Dimensional Fund Advisors LP using yield curve data (USD) and assuming various holding periods. The input data is sourced from Bloomberg BVAL. The expected
returns are calculated as forward rates based on the Bloomberg data. There is no guarantee that any product or strategy offered by Dimensional will achieve the returns shown. Any forward-looking
statements speak only as of the date they are made, and Dimensional assumes no duty and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous
assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements.
Security Specific Expected Returns

For illustrative purposes only.

Short-Term Equity Returns
Security Deep Dive

For illustrative purposes only.

Deep Dive Market Data

For illustrative purposes only.

Short-term Equity Return Filter

For illustrative purposes only.

Implementation of Research

Short-term equity return Conclusion for bonds

Highly positive Delay selling

Highly negative Delay buying

Neither highly positive nor Rely on forward rates and portfolio

highly negative constraints for bond selection
Appendix
 Summary Statistics
Market Spearman
Equally Value rank 50th
Weighted Weighted Standard correlation to 5th 10th 20th Percentile 80th 90th 95th
Average Average Deviation Forward Rate Percentile Percentile Percentile (Median) Percentile Percentile Percentile
Market Value (USD '000) 688,557 1,289,564 640,496 -0.10 234,694 252,443 294,378 471,942 915,133 1,381,638 1,952,399
Yield to Maturity 4.57% 4.41% 1.93% 0.96 2.75% 2.96% 3.30% 4.21% 5.37% 6.36% 7.57%
One-Month Forward Rate (annualized) 5.70% 5.55% 2.23% 1.00 3.20% 3.52% 4.07% 5.41% 6.84% 7.93% 9.16%
Maturity 5.14 5.11 3.16 0.75 1.37 1.70 2.33 4.42 7.69 9.04 10.74
Duration 4.24 4.27 2.11 0.73 1.33 1.62 2.20 3.92 6.25 7.16 7.92
Credit Rating (AAA=1, B-=16) 7.45 6.89 2.73 0.50 3.26 4.31 5.50 7.09 9.45 10.58 12.58
Credit Spread (over m. Treasury) 1.84% 1.68% 1.74% 0.82 0.60% 0.72% 0.90% 1.36% 2.34% 3.38% 4.59%
Forward Rate Spread (over m. Treasury) 2.13% 1.97% 1.84% 0.86 0.69% 0.85% 1.07% 1.64% 2.77% 3.84% 5.09%
ln(Market Capitalization) 23.89 24.39 1.39 -0.40 21.58 22.05 22.70 23.90 25.21 25.79 26.13
ln(Total Public Debt Outstanding) 15.73 16.35 1.38 -0.22 13.36 13.88 14.51 15.76 17.01 17.71 17.95
ln(Book-to-Market) -0.81 -0.76 0.75 0.25 -2.13 -1.73 -1.36 -0.74 -0.21 0.05 0.30
Profitability 0.35 0.36 0.37 -0.14 0.06 0.11 0.17 0.28 0.43 0.62 0.92
Leverage 31% 34% 32% 0.18 -11% 0% 9% 30% 54% 70% 79%
Distance to Default 8.38 7.54 5.20 -0.25 1.65 2.31 3.79 7.59 12.41 15.44 18.29
Default-Adj Credit Spread ("Value") 0.00 -0.11 0.56 0.75 -0.87 -0.68 -0.46 -0.03 0.45 0.75 0.97
Short-Term Equity Return 0.73% 0.67% 7.55% -0.02 -10.79% -7.73% -4.57% 0.66% 5.89% 9.03% 12.35%
Equity Momentum 3.78% 3.57% 16.61% -0.08 -21.03% -14.64% -8.16% 3.12% 15.35% 22.86% 30.52%
Short-Term Bond Return 0.48% 0.49% 1.75% 0.10 -1.40% -0.72% -0.23% 0.44% 1.19% 1.75% 2.49%
Bond Momentum 2.47% 2.52% 3.85% 0.15 -1.96% -0.45% 0.70% 2.36% 4.21% 5.57% 7.25%
Short-Term Credit Premium 0.12% 0.13% 1.71% 0.03 -1.69% -0.95% -0.44% 0.10% 0.69% 1.24% 2.01%
Credit Momentum 0.64% 0.68% 3.76% 0.06 -3.63% -2.00% -0.83% 0.56% 2.09% 3.41% 5.11%

Past performance, including hypothetical performance, is no guarantee of future results.

Filters were applied to data retroactively and with the benefit of hindsight.
Source: Bond data are from Bloomberg Barclays and include constituents of the US Aggregate Index and US High Yield Bond Index. Equity data are from Bloomberg Global Stock database and CRSP. US
issuers and USD-denominated debt only. The sample period is January 2000 to December 2018. See “Alternative Variables and Expected Bond Returns” for additional information on the variables used.
#66464-0918
 Disclosures
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