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Smart credit investing: harvesting factor premiums

12-01-2015 | Insight | Jeroen van Zundert, Patrick Houweling, PhD Although most factor research focuses on the equity market, the concept and benefits of factor investing apply equally well to the corporate bond market. A smart way of investing is combining the factors into a multi-factor credit portfolio in order to diversify across factors. A multi-factor portfolio retains the high Sharpe ratio of the individual factors, but with smaller drawdowns and lower tracking error versus the market. Moreover, in a multi-asset portfolio, corporate bond factors also add value, beyond the equity factors.

  • The Size, Low-Risk, Value and Momentum factors have high returns and Sharpe ratios in the corporate bond market. However, they may outperform or underperform the market for prolonged periods, resulting in drawdowns and high tracking errors.
  • By combining factors in a multi-factor portfolio, the drawdowns and tracking errors become much smaller, while the high returns and Sharpe ratios are conserved.
  • Corporate bond factors can add about 1% return a year in a strategic multi-asset portfolio, regardless of whether the portfolio is already allocated to equity factors.
Multi-factor credit portfolios: more stable alphas
We have found strong empirical evidence for the existence of Size, Low-Risk, Value and Momentum factor premiums in the corporate bond market. All factors have substantially higher returns and Sharpe ratios than the market. The tracking errors, however, are relatively large, highlighting the risk of underperforming the market over shorter investment horizons. By investing in a multi-factor portfolio, which diversifies across the four factors, the tracking error and drawdowns versus the market are reduced while the high returns and Sharpe ratios are preserved.

Corporate bond factor allocation pushes up the Sharpe ratio of a multi-asset portfolio
As most investors are also invested in other asset classes, such as equities or government bonds, we have researched the added value of corporate bonds factors in a multi-asset portfolio as well. We have analyzed a hypothetical multi-asset portfolio containing 20% government bonds, 40% equities, 20% investment grade corporate bonds and 20% high yield corporate bonds. In a traditional portfolio, all allocations are to the market indices. Next, we have tested three alternative allocations, where we:

  1. allocate only the equity portfolio to a multi-factor portfolio
  2. allocate only the corporate bond portfolios to the multi-factor portfolios and
  3. allocate both the equity and corporate bond portfolios to multi-factor portfolios

Figure 1: Sharpe ratios market and factor portfolios over the risk-free rate for government bonds, investment grade (IG), high yield (HY) and equities   
grafiek-1-smart-credit-inv-500 px.jpg
Sources: Robeco, Barclays, Bloomberg, Data Library Kenneth French. Period: 1994-2013.   


Figure 2: Sharpe ratios multi-asset portfolios over the risk-free rate
grafiek-2-smart-credit-inv-500px.jpg
Sources: Robeco, Barclays, Bloomberg, Data Library Kenneth French. Period: 1994-2013.

Figure 1 shows the Sharpe ratio of the market and the multi-factor portfolio per asset class. The improvements of the factor portfolios versus their respective market indices are substantial, with Sharpe ratios increasing by 0.16 (IG), 0.28 (HY) and 0.26 (equities). Figure 2 shows the Sharpe ratio of the multi-asset portfolio and the three alternative portfolios. Investing in the corporate bond multi-factor portfolios boosts the Sharpe ratio from 0.70 to 0.81. Investors that already allocate to the equity factors and decide to invest in the corporate bond multi-factor portfolio too, see their Sharpe ratio grow from 0.89 to 0.97. In both cases, the corporate bond factor allocation contributes almost 1% to the improved return, while the volatility is virtually unchanged.

Robeco’s enhanced approach: smarter definitions and portfolio construction
The results we have analyzed the benefits of factor investing following academic conventions. However, Robeco research has shown that it is possible to improve upon these results in two ways, i.e. by using:

  1. smarter factor definitions and
  2. smarter portfolio construction rules
Smarter factor definitions
To smarten the factor definitions, it is important to understand the latent risks in each factor and to mitigate these risks if they are not properly rewarded with higher returns. Moreover, since risk itself is unobservable and multi-dimensional it is advisable to diversify across risk measures. We found that is especially beneficial to expand the scope of the risk measures beyond bond market characteristics, and use accounting and equity data as well. For instance for Low-Risk, we do not only control for risk via rating and maturity, but also for the amount of leverage the company is taking on, and how much risk its equity shows. To enhance Value, we do not only look at rating and maturity to calculate the ‘fair’ credit spread, but also at company characteristics. Moreover, we use equity market information in our Momentum definition.

Smarter portfolio construction rules
Besides smarter factor definitions, the portfolio construction rules can also be made smarter to enhance performance. Turnover, for example, can be reduced substantially by not immediately selling a bond once it no longer belongs to the top decile. By postponing the sell, for example until the bond drops out of the top 50%, investors can save costs. Also, we have found that it pays off to take other factors into account while constructing the portfolio.

Conclusion
There is strong empirical evidence for the existence of Size, Low-Risk, Value and Momentum factor premiums in the corporate bond market. By investing in a multi-factor portfolio, the tracking error and drawdowns versus the market are reduced in comparison with single-factor portfolios, while the high returns and Sharpe ratios are preserved.
In a multi-asset context, by allocating to corporate bond factors investors can improve the Sharpe ratio by 0.1 and their return by about 1%, regardless of whether they already allocate to factors in their equity portfolio. Although these results are already strong, there is still much to be gained by enhancing the investment process. This can be done by using smarter factor definitions and by improving portfolio construction rules.

Patrick Houweling, PhD

Portfolio Manager, Senior Quantitative Researcher
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Patrick Houweling, PhD
Portfolio Manager, Senior Quantitative Researcher