How do I implement factor tilts in a bond portfolio?

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AcadiFi · Accepted Answer

Factor tilts in bonds are implemented in three steps: factor definition, bond scoring, and portfolio construction with neutralization of unwanted exposures. Factor definition: for value, define score as residual OAS after regressing OAS on duration, rating, sector, and currency dummies. A bond with OAS +30 bps higher than predicted by its characteristics is a 'value' bond. For carry, score is yield-to-worst minus risk-free-rate of similar duration. For momentum, score is trailing 3-month excess return minus index excess return in same cell. Bond scoring: compute each factor score for every bond in the universe monthly. Standardize scores within cells (sector x duration bucket x rating bucket) to prevent, for example, carry factor from simply loading on long duration or low rating. Portfolio construction at Hardcastle Systematic: rank bonds by composite factor score, build a portfolio that overweights top decile and underweights bottom decile within each cell. Neutralize aggregate risk exposures: the portfolio duration must equal benchmark, credit quality equal benchmark, sector allocation within +/- 1% of benchmark. This isolates the factor premium from bulk market-risk tilts. Implementation uses optimization: minimize tracking error subject to factor exposure targets and risk neutralization constraints. Rebalance monthly or quarterly. Expected turnover 80-150% annually, significantly higher than passive but manageable with patient trading and crossing. Key watchpoint: transaction costs can erode 30-70% of gross factor premium if trading is not optimized. Use implementation-shortfall analytics and internal matching where possible. ```mermaid flowchart LR A[Universe] --> B[Score
factors] B --> C[Rank
within cells] C --> D[Optimize
tilts] D --> E[Neutralize
beta] ```

How do I implement factor tilts in a bond portfolio?

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