Tim Olson
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description, tags
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| The value factor strategy for bonds selects bonds with the highest actual credit spread relative to a theoretically predicted spread from a cross-sectional regression, going long undervalued bonds in the top decile. |
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Value Factor
Section: 5.10 | Asset Class: Fixed Income | Type: Factor / Value
Overview
"Value" in fixed income is defined by comparing a bond's observed credit spread to a theoretically predicted (fair value) credit spread. Bonds trading with a spread significantly above their predicted fair value are cheap (high value); those below are expensive. The strategy buys the top-decile bonds by value score.
Construction / Mechanics
Step 1: Estimate fair value spreads via a cross-sectional linear regression across N bonds (i = 1,...,N):
S_i = Σ_{r=1}^K β_r · I_{ir} + γ · T_i + ε_i (410)
where:
- S_i: observed credit spread of bond i (bond yield minus risk-free rate)
- I_{ir}: dummy variable = 1 if bond i has credit rating r, 0 otherwise (K ≤ 21 ratings)
- T_i: maturity of bond i
- β_r, γ: regression coefficients (note: no separate intercept since Σ_r I_{ir} = 1 for each bond)
- ε_i: regression residual
The constraint:
Σ_{r=1}^K I_{ir} = 1 for all i (412)
(each bond has exactly one credit rating, so the intercept is absorbed into the rating dummies)
Step 2: Compute fair value spread:
S_i* = S_i - ε_i (411)
(the fitted value from the regression)
Step 3: Compute value score — either:
- V_i = ln(S_i / S_i*), or
- V_i = ε_i / S_i* = S_i / S_i* - 1
Step 4: Select portfolio — long bonds in the top decile by V_i (most undervalued).
Payoff / Return Profile
- Profits when cheap bonds (high V_i) revert toward fair value, compressing their spreads.
- Returns driven by credit spread compression and coupon income.
- The strategy assumes mean-reversion in credit spreads around their rating- and maturity-implied fair value.
Key Parameters / Signals
- S_i: observed credit spread (bond yield minus risk-free rate)
- S_i*: fair value credit spread from cross-sectional regression
- V_i = ln(S_i/S_i*) or V_i = S_i/S_i* - 1: value score
- Top decile by V_i: the portfolio selection criterion
Variations
- Long-short: long top decile (cheap bonds), short bottom decile (expensive bonds).
- Separate regressions for Investment Grade and High Yield universes.
- Additional cross-sectional controls (e.g., industry, liquidity) can be added as regressors.
Notes
- "Value" in fixed income is harder to define than in equities because bonds have finite lifetimes and their spreads are heavily influenced by credit ratings and maturity.
- The cross-sectional regression should be run on bonds within a comparable universe (e.g., only IG or only HY) to ensure meaningful comparisons.
- Credit spread data may be noisy; outliers from bonds near distress can distort the regression.
- Shorting corporate bonds is operationally challenging; the strategy is often implemented long-only.