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Applying the low-risk anomaly to corporate bonds: a Q&A with Patrick Houweling

18-04-2012 | Insight | Patrick Houweling, PhD Conservative Credits invests in the low-risk bonds of low-risk issuers. Patrick Houweling, Senior Researcher, Credits, led the strategy’s development. In this Q&A session, he explains how it works.

Background

Conservative Credits is a new strategy from the Robeco Quantitative Strategies and Fixed Income teams. It exploits the low-risk anomaly in corporate bonds by investing in short-term credits with low distress risk. The Conservative Credits strategy results in a diversified investment-grade credit portfolio that can deliver superior risk-adjusted returns over the credit cycle. Beta is significantly reduced through the combination of investing in the low-risk instruments of low-risk companies and their low-risk instruments.
 
How do you define the low-risk anomaly in credits?
We see the low-risk anomaly in credits as primarily the combination of two factors: maturity and distress risk.

The maturity effect is based on our research[1] that bonds with the shortest maturities outperform longer maturity bonds on a risk-adjusted basis. Shorter maturity bonds have higher average returns, lower volatility and therefore a much higher Sharpe ratio. Moreover, we found that the short-maturity effect is present in all segments of the credit universe and within all sectors and rating classes. It is also independent of whether credit markets are rising, falling or flat.

The distress-risk effect is based on our application of the proprietary distress-risk model developed for the Robeco Conservative Equity strategy to bond issuers. We found that bonds issued by companies with high distress risk and high leverage had more volatility, but not higher returns. Distress risk is unrewarded in bond markets, and the relationship between distress risk and returns is flat.
 
How do you exploit it?
We exploit the low-risk anomaly by first screening a universe that combines investment grade and high-yield corporates, agencies and supranationals, based on time to maturity and credit rating. We want to identify bonds with six years or less remaining to maturity and with a BB-rating or better. We then rank these issuers based on a proprietary quantitative model pointed toward low-risk factors and emphasizing distress risk.  We want to invest in low-risk bonds with attractive upside potential, based on valuation and sentiment.

We have found that the anomaly is strongest if we control first for maturity and then factor in the distress-risk dimension. If you sort on distress risk first, you naturally find that the highest-quality companies issue the longest term bonds, which interferes with the short-term maturity effect.

Is Conservative Credits a rules-based quantitative strategy?
For the most part, Conservative Credits is a rules-based quantitative strategy. Eligible credits, however, also undergo fundamental analysis by our credit analysts to further mitigate downside risks.  Here, we want to identify nonquantifiable risks that are specific to credits, such as weak indentures or missing guarantees.

How else do you limit risk?
Concentration limits are used to further reduce risk, including a 25% portfolio sector limit, which lessens the dominance of the financials or any other sector in the portfolio. We make sure the model portfolio is diversified across names, sectors, regions and maturities. The portfolio is also tolerant of downgrades, which we find significantly improves returns while only slightly increasing risk. As long as a bond that slips into the high-yield category does not default, we are not too concerned and we keep it in the portfolio. It would be worse to sell such a bond at the fire-sale prices that occur due to forced selling by investors with regulatory restrictions on high-yield holdings.
 
How do you expect institutional investors to use the strategy?
Initially, we thought investors would approach Conservative Credits in a similar way to how they adopted Conservative Equity. Typically, Conservative Equity clients shift a portion of equity-market beta exposure to lower-risk equity exposure, which enables them to reduce portfolio volatility while retaining equity market returns.

What we have found with Conservative Credits, however, is that in addition to allocating to the strategy from an existing credits allocation, our clients are also interested in it as a solution for existing government bond portfolios and the shrinking number of triple-A rated sovereigns. With a shift in exposure from governments to Conservative Credits, they would demonstrate a preference for a diversified credit portfolio with approximately 100 names over a government bond portfolio with concentrated country risk.

For clients with no existing credits exposure, an allocation to Conservative Credits would mean that credit beta shifts from 0 to approximately a half-way point between government bonds and higher risk credits. We believe institutional investors will find this middle ground attractive.
 
Why is the beta so low for Conservative Credits?
It is low because we are selecting both low-risk issuers and their low-risk bonds. Risk reduction is applied to both the company and the instruments. It enables fixed income investors to play the low-risk anomaly in a very strong way.

What are your expectations for performance?
Extensive portfolio simulations show that in comparison with an investment-grade bond index, the Conservative Credits strategy preserves capital during bear markets, performs in line with rising markets and tends to lag in strong bull markets. Results of a simulation over the period 2003-2011 using the Barclays Capital EU Investment Index appear below.
 
applying-the-low-risk-anomaly-to-corporate-bonds-a-q-a-with-patrick-houweling.jpg

Based on portfolio simulations comparing the performance of the Conservative Credits portofolio with the Barclays Capital EU Investment Grade Index from January 2003 through September 2011. Returns are in excess of duration-matched Treasury bonds and after transaction costs.

Source: Robeco Quantitative Strategies

Why is Conservative Credits relevant in today’s market?
Financial markets as a whole have been very volatile over the past four years. The ability to limit downside risk while generating equity returns has generated a great deal of interest in low-volatility equity strategies in general and Conservative Equity in particular.

Volatilities in credit markets have also been very high, reaching peaks last seen in the 1930s. Today,  credit spreads remain elevated at high levels. The past few years have made investors, in both equities and fixed income, more aware of how downside risk and underperforming in declining markets hurts long-term returns. Robeco Conservative Equities and, now, Conservative Credits, answers the need for market returns with less risk.

[1] Daniel Haesen, Patrick Houweling, Sander Bus, “Exploiting the short-maturity effect in corporate bonds,” Robeco, March 2009. 
 
Read more about Conservative Credits in Robeco’s publication, “The low-risk anomaly in credits,” available to clients on request.

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