The authors’ first finding was that risk and return were positively related across credit ratings, but that the relation tended to be flat within one and the same credit rating. They used the Distance-to-Default (DtD) measure of Merton (1974) to construct quality and value factors.
For quality, they selected low-risk (high DtD) issuers within credit ratings. For value, per credit rating, they regressed credit spreads on DtD and selected high residual spread issuers. The factors were used in monthly rebalanced quintile portfolios, as well as in a long-only optimized portfolio, controlling for interest rate risk, credit exposure and turnover. These portfolios were tested on USD Investment Grade (IG) and High Yield (HY) universes from 2004 to 2016.
The after-transaction cost information ratios were around 0.45 for IG and 0.80 for HY for both factors. Combined, the IR is 0.60 for IG (1.12 for HY), showing the diversification benefits to be gained from multi-factor investing.
Note that what this paper calls ‘quality’ is commonly called the ‘low risk’ factor. At Robeco, we define quality at the level of the issuer, by looking at profitability, earnings quality, and conservative behavior.
1Kang, Parker, Radell & Smith, 2017, ‘Reach for safety’, SSRN working paper, no.3037745
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