Factor-Based Tactical Bond Allocation and Interest Rate Risk Management

Abstract

This paper reports two composite bond market factor investment strategies for the Swiss and global sovereign bond markets. The composite factor strategies can be used as a tool for tactical asset allocation decisions between bonds and cash, and to base the duration debate upon. As such, the output of our bond market factors can guide tactical interest rate views and, therefore, interest rate risk management. To construct the composite factors, we use four economically meaningful, individual factors. Following an investment strategy based on a composite bond market factor, constructed as the equally weighted average of individual components, we are able to outperform cash as well as the static buy-and-hold strategy in terms of Sharpe ratio, annualized standard deviation, and maximum drawdown. Testing the composite and individual factors on their performance during periods of historical rising interest rates, we observe improved drawdown results compared to holding the underlying asset passively.