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The quality of low-risk credits

The quality of low-risk credits

14-09-2016 | Research

Recently a new factor was added to the literature: Quality. In credits, we see Quality as a natural extension of pure Low-Risk. All our credit factor models have used Quality since inception, and have expanded its use over the years.

  • Frederik  Muskens
    Frederik
    Muskens
    Quantitative Researcher
  • Patrick  Houweling
    Patrick
    Houweling
    Portfolio Manager
  • Mark  Whirdy
    Mark
    Whirdy
    Quantitative Credit Portfolio Manager
  • Jeroen  van Zundert
    Jeroen
    van Zundert
    Researcher Quantitative Credits

Speed read

  • Quality firms are safer, more profitable, and more conservatively managed
  • Their bonds historically had higher risk-adjusted returns
  • Quality is qualitatively and quantitatively similar to Low-Risk

Factor investing has rapidly gained popularity. Well-known and proven factors are Low-Risk, Value, Momentum and Size.  A more recent addition is the Quality factor. What constitutes Quality is less well defined. At Robeco, we define high-quality firms as firms with high profitability, high earnings quality, and conservative behavior.

One may wonder why a Quality portfolio generates a premium versus the market. After all, who does not like profitable, cash flow-generating, well-managed companies? Academic researchers investigated two possible explanations: the risk view and the behavioral view. They concluded that a risk-based explanation is unlikely, because a Quality portfolio has lower volatility than the market and tends to outperform in market downturns. Therefore, a behavioral explanation is more likely: although investors are willing to pay up for stocks and bonds of high-quality firms, the market is underpricing these securities versus low-quality firms. Bouchaud et al. (2016) argue that “investors systematically underweight the information contained in Quality-like signals; they are too focused on other indicators such as Earnings per Share […]”.

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Corporate bond portfolio of Quality firms has superior Sharpe ratio

We evaluate the Quality factor over the 1994-2015 period in the USD Investment Grade and USD High Yield corporate bond markets. We create five corporate bond portfolios: Q1 contains the 20% bonds of the highest-quality firms, Q2 contains the next 20%, and so on, until Q5, which contains the 20% bonds of the lowest-quality firms. We use a holding period of 12 months. The returns and volatilities of each quintile portfolio are shown in Figure 1. 

Figure 1  |  Risk-return plot of Quality quintile portfolios for USD Investment Grade and USD High Yield
Source: Robeco, Barclays, FactSet. Sample period January 1994 – December 2015.

We see that high-quality firms (Q1) have higher returns and lower volatility than low-quality firms (Q5). As a result, the high-quality portfolio has a much higher Sharpe ratio than the low-quality portfolio. 

Quality factor compares well with other factors

Next we compare Quality with other proven factors: Low-Risk, Value, Momentum and Size. Figure 2 shows that all factors generated higher Sharpe ratios than the market and that the Sharpe ratio of the Quality factor is of similar magnitude as the Sharpe ratio of the other factors. 

Figure 2  |  Sharpe ratios of the market and top quintile Quality, Low-Risk, Value, Momentum, and Size portfolios for USD Investment Grade and USD High Yield
Source: Robeco, Barclays, FactSet. Sample period January 1994 – December 2015

Similarity between Quality and Low-Risk: Comparing characteristics

It is intuitively clear that Quality is similar to Low-Risk. For example, Quality dislikes loss-making firms and it is not hard to imagine that unprofitable firms are also more risky. Further, Quality favors firms that are conservatively managed, e.g. firms that prefer redeeming their debts to aggressive investments. It is clear that debt reduction also reduces default risk.

We find strong empirical evidence for the intuitive similarity between Quality and Low-Risk when analyzing Quality-characteristics of Low Risk-sorted portfolios in Figure 3: the low-risk portfolio (Q1) is invested in companies which are more profitable and generate more cash flows, and the high-risk portfolio (Q5) contains firms which are less profitable and have lower cash flows.

Figure 3  |  Average profitability and cash flows for Low-Risk sorted portfolios for USD Investment Grade and USD High Yield
Source: Robeco, Barclays, FactSet. Sample period January 1994 – December 2015.

Similarity between Quality and Low-Risk: Comparing returns

Next, we provide evidence on the similarity between Quality and Low-Risk by analyzing returns. We already saw in Figure 1 that the lower the ranking on the Quality factor, the larger the realized return volatility. Hence, the Quality of a firm is predictive of the future volatility of its bonds.

We analyze the outperformance versus the market of the Quality and Low-Risk Q1 portfolios. Both factors generate statistically significant alphas. Moreover, the outperformances of both factors are negatively related to the market, because their market beta is negative. So both Quality and Low-Risk typically outperform in a bear market and underperform in a bull market.

Finally, we provide a direct comparison between the Quality and Low-Risk factors by regressing their outperformances on each other. We see that the betas are around 0.6 and that they are highly statistically significant. This is more evidence that the Quality and Low-Risk factors are similar. We stress that the factors are not identical, because the betas are not equal to 1. Furthermore, the alphas are still sizeable: 0.21% for Investment Grade and 0.55% for High Yield. So, also after controlling for the Low-Risk exposure of Quality, it generates alpha.

To conclude, Quality and Low-Risk are both strong factors. We do see that they display similar behavior. Quality has added value beyond Low-Risk, but this is statistically weaker than the added value of both factors beyond the credit market risk premium.

Use of Quality and Low-Risk factors in Robeco’s factor strategies

Because Quality and Low-Risk factors are both quantitatively and qualitatively similar, we combine them in a single Low-Risk/Quality basket in our factor models. So far, we have called this factor ‘Low-Risk’, even though it also contains Quality variables. For example, as mentioned above, leverage (which fits the safety theme of Quality) has been part of our Low-Risk factor since the inception of the factor strategies. In recent years, we have gradually added more Quality variables to the Low-Risk factor, such as profitability. All our quantitative multi-factor ranking models contain the combined Low-Risk/Quality basket.

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