latamen
Low-risk stocks behave like bonds

Low-risk stocks behave like bonds

13-10-2020 | Research
Low-risk stocks are very bond-like. Questioning unrealistic assumptions about the investment horizon reveals that falling rates are positive for low-risk stocks. This means that low-risk stocks are attractive not only because of their alpha, but also because they provide a good match with typical liabilities of institutional investors.
  • David Blitz
    David
    Blitz
    Head of Quant Research

Speed read

  • Asset-pricing literature implicitly assumes a one-month investment horizon
  • Questioning this assumption shows low-beta equities correlate with bonds
  • Low-beta stocks thus not only offer alpha potential but also liability-hedging properties

Most of the asset-pricing literature implicitly assumes a one-month investment horizon, and one-month bills are therefore considered as the risk-free asset. But this assumption seems clearly unrealistic, and it is therefore worth examining the potential distortions it may cause in financial modeling. 

In a new research paper,1 we investigate this question by searching for the actual risk-free rate implied by investors’ behavior in equity markets. For that, we start by looking at what the theoretical implications would be if the CAPM is tested assuming that one-month Treasury bills are the risk-free asset, while the true risk-free asset is in fact an ‘N-year’ bond.

The CAPM states that E(R)= Rf + β x (E(Rm)-Rf),2 and a simple derivation from this formula shows that if the incorrect risk-free asset is assumed, it should show up in stocks with low equity betas (β) co-moving with bond returns. Specifically, if N-year bonds are the risk-free asset, low-beta stocks should exhibit a positive exposure to N-year bond returns.

In other words, if an investor’s horizon is indeed much longer than one month, low-beta stocks should exhibit a positive correlation with multi-year bond prices, not short-term bills, and thus benefit from falling interest rates. Meanwhile, high-beta stocks should exhibit a negative correlation with multi-year bond prices, and thus benefit from rising rates.

Our empirical tests strongly confirm this hypothesis. We find that low-beta stocks are indeed very bond-like, while the opposite is true for high-risk stocks. What’s more, we find that the negative relation between the equity beta and the bond beta of a stock is almost perfectly linear.

This means, for example, that a stock with an equity beta of 0.7 will show a bond beta of 0.3, while a stock with beta of 1.5 has a bond beta of -0.5. The combined stock and bond betas always neatly add up to 1. These results are valid for the US stock market but also for other markets. Also, they are robust over different sample sub-periods.

Finally, by relating stock returns to the returns of bonds with different maturities, we believe it is possible to pinpoint that bonds with a maturity of about 5 years provide the best fit. Hence, the risk-free asset which financial models ought to consider is bonds with a maturity of about 5 years, and definitely not one month.

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

Implications for risk-adverse investors

Besides their repercussions for the asset pricing literature, our findings also have important implications for investors trying to reduce risk in portfolios. While the classic way to cut equity beta is to increase allocation to bonds – say, for example, 70% to equities and 30% to bonds – investors should be mindful that this type of mix may not lead to the best outcome.

Allocating to low-risk, bond-like stocks, such as those we hold in our Conservative Equities portfolios, instead of to bonds, we believe allows investors to benefit from the alpha that low-risk stocks are known to offer. The bond-like properties of low-risk stocks also makes them attractive to investors who need to hedge liabilities.

1 Blitz, D. C., 2020, “The Risk-Free Asset Implied By the Market: Medium-Term Bonds Instead of Short-Term Bills”, The Journal of Portfolio Management.
2 Where E(R) is the expected return, Rf is the risk-free rate, β is the market risk and E(Rm) is the expected market return.

Logo

Important information

The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).

This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.

This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.

I Disagree