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Value investing has been researched extensively in equity markets and has recently been shown to exist in credit markets as well. In our fundamental Global Credits strategy, the Value factor also plays an important role. Here we look for cheap stocks with strong mean reversion potential.
The value factor can deliver significant excess returns. Among equity investors it is a well-known phenomenon, which has been researched for over 80 years. Recent studies by Robeco have shown that a value factor also exists in corporate credit markets.
In our fundamental Global Credits strategy, we also aim to profit from the value factor. We look for bonds that are too cheap and have a strong potential to return to fair levels. This is known as mean reversion. The cheaper a credit, the bigger its mean reversion potential.
So what is cheap? Figure 1 shows credit spreads relative to maturity and rating. In this example, bond 1 is cheap versus the fair spread curve for A-rated bonds. Bond 2 is expensive versus its BBB curve, even though it has a higher spread than bond 1. From a quantitative point of view, bond 1 therefore appears to be cheap.
Figure 1 | Value examples using rating and maturity as risk measures
In Figure 2 we have divided the credit universe into five quintiles, ranging from cheap to expensive. The chart shows that cheaper credits offer the strongest mean reversion potential.
Figure 2 | Cheap credits mean-revert and generate stronger returns
At the Robeco Credit team, in which the quantitative portfolio managers are also embedded, we benefit from these quantitative insights. However, in our fundamental credit strategies we also look for value in a more subjective way. Our aim is to make sure we are rewarded for taking risk. We therefore screen global credit markets for value that has been overlooked.
Having established that the cheapest credits offer the highest return potential, is not enough. Fundamental research is necessary to control risk. After all, some credits are cheap for a reason. Avoiding the losers remains a key objective rather than buying every winner. To this end, we need to understand the macro environment and identify improving or deteriorating businesses.
Understanding the macro environment means that we determine the phase the credit cycle is in. If we expect a recession, a cyclical credit might be cheap for good reason, making bond 1 in figure 1 a value trap we would like to avoid.
To identify improving or deteriorating businesses, a Credit Committee discusses every single potential investment. In this Committee, the analyst, head of research and portfolio managers discuss the analyst’s fundamental credit analysis.
By understanding the macro environment and thoroughly analyzing individual businesses, we maximize the likelihood of finding valuations that have deviated too much from their fair value because of investor biases, not because of real credit risk.
Why do value anomalies exist? The most likely explanation is a combination of behavioral biases and market segmentations.
These are extensively described in literature. We mention a few:
Value can also be caused by market segmentation. Investors sometimes buy credits they should not have bought. For example, an investor may have bought credits that were just outside his mandate (BB credits in an investment grade portfolio). They do this to obtain short-term gains, without fully appreciating the risks or lacking research resources. Panic or fear can then drive selling pressure.
After the initial overreaction, value investors realize events have caused credits to become too cheap and offer over-compensation for the risk (value). We will have allocated research resources to these cases and started buying these risk assets, enjoying the mean reversion that will follow. Often the risk premium is so big that we do not even have to buy the riskiest assets. The best assets may already offer great mean reversion potential. Shorter dated cheaper credits appear to offer the best opportunity.
To profit from value opportunities and avoid following the herd, we advocate a contrarian stance. Our team’s natural reflex needs to be that when big events happen (e.g. Brexit) and markets (over) react, it starts a discussion to take a contrarian position.
To be able to capture the premium offered by the value factor while mitigating risks we apply a smart portfolio construction process. In constructing the portfolio we measure positions in Risk points - more commonly known as DTS (Duration times spread) - and aim to equally weight positions. This way we construct the portfolio based on the amount of risk a position adds, rather than the amount of debt a company happens to have outstanding.
Because of our value approach, the Global Credits portfolio will often have a shorter spread duration, a higher yielding but investment grade profile, and value opportunities from around the world. In this portfolio, investors’ behavioral biases offer opportunities for contrarian investment positions.