An empirical test of factors in the unchartered waters of EM credits

An empirical test of factors in the unchartered waters of EM credits

30-09-2019 | Research
Emerging credit markets have seen tremendous growth over the past two decades. Starting at USD 50 billion in 2001, they reached USD 2 trillion in 2018. Yet the empirical research carried out on these markets remains limited.
  • Patrick  Houweling
    Co-Head of Quant Fixed Income
  • Frederik  Muskens

Speed read

  • We tested the existence of well-known factors in EM corporate bonds
  • We found that allocating to factors in the EM credit market is attractive
  • This is true even for those who already allocate to factors in DM credit or equities

As part of our continuous effort to test the existence of factor premiums off the beaten track of global equities, we have investigated whether well-known factor premiums such as size, low risk, value and momentum can also be found in emerging market corporate bonds.

Using the generic factor definitions from our award-winning research paper on factor investing in developed market (DM) corporate bonds1, this new research2 shows that allocating to size, low risk, value and momentum in emerging market (EM) credits yields significantly positive risk-adjusted returns, with Sharpe ratios ranging from 0.57 to 0.85 versus 0.37 for the market.

More specifically, portfolios based on size, value and momentum significantly outperform the market. Meanwhile, a portfolio based on the low-risk factor delivers a return that is close to the market’s, but with roughly a third of the volatility.

Controlling for market exposures, we found alphas that are economically meaningful and statistically significant, with annualized CAPM alphas ranging between 1.46% and 5.03%. We also found that a multi-factor portfolio that allocates equally to the four factors obtains an information ratio of 1.19, which is higher and more significant than the information ratios obtained by single-factor portfolios.

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Positive alphas

Our research also shows that allocating to factors in the EM credit market is attractive, even for investors who already allocate to factors in DM credit or equity markets. All the factor portfolios have significantly positive alphas after controlling for DM credit or equity factors. Interestingly, the size and momentum EM credit factor portfolios show a statistically significant relationship with their DM credit counterparts and, therefore, seem to benefit from broader factor premiums.

Part of the risk-adjusted outperformances of the factor portfolios is driven by bottom-up country allocation. When we constructed country-neutral factor portfolios, we found that the Sharpe ratios and, except in the case of low risk, alphas decline. The Sharpe ratio of the multi-factor portfolio declines from 0.73 to 0.66, but remains highly significant; as too does the alpha controlled for exposures to DM credit factors, which declines from 2.45% to 1.84%.

These results indicate that factor premiums exist both within and across EM countries

These results indicate that factor premiums exist both within and across EM countries. In addition to being robust within countries, our results are robust and hold within sectors, ratings, maturity segments and liquidity segments. In other checks, we found that our results are also robust to portfolio construction choices.

Out-of-sample test of factors

In short, our new research confirms the existence of factor premiums in EM credits and serves as a true out-of-sample test of our earlier research on DM credits. What is more, these factor premiums are largely unique to EM because they cannot be explained by exposures to DM factors or equity factors. A variety of sensitivity analyses show that the premiums are robust and can be found in subsegments of the market.

Read the related working paper on SSRN.

1 Houweling, P. and Van Zundert, J., 2017, ‘Factor investing in the corporate bond market’, Financial Analysts Journal.
2 Dekker, L., Houweling, P. and Muskens, F., 2019, ‘Factor investing in emerging market credits’, working paper.


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