The majority of assets owned by insurers are invested in investment grade fixed income. In search of a way to achieve more capital-efficient returns, diversification and illiquidity premiums, insurers often turn to high yield markets and alternative asset classes. But we argue factor investing in corporate bonds is an attractive alternative approach to generating capital-efficient returns.
Insurance companies are significant investors in credits and hold capital buffers to protect their portfolios against negative events. Insurers are also always looking for the best way to diversify their investments and to enhance their return on insurance capital.
Factor-based credit strategies provide an attractive alternative to traditional, fundamental, research-based credit strategies for insurers. Their differentiated investment style and their ability to utilize a broader investment universe explain why factor strategies provide an important source of diversification relative to the fundamentally managed portfolios of insurers.
A multi-factor credit strategy uses a highly systematic method to construct the portfolio, taking into account multiple quantitative factors and neutralizing the portfolio’s exposures in terms of interest rate duration and credit beta. Meanwhile, fundamental strategies typically follow only one style, often carry or value, and regularly take duration and/or beta bets.
In terms of the investment universe, a factor-based strategy can efficiently invest in all companies and bonds, irrespective of their size. Fundamental managers inevitably have to focus on a smaller subset, given their limited resources for analyzing issuers. Generally, this subset consists of the larger, more liquid names and their more recently issued bonds.
Because of these differences, while the realized returns of most fundamental strategies tend to be positively correlated, the realized returns of our factor strategies are negatively correlated with those of their fundamental peers. Adding a factor strategy to a portfolio of fundamentally managed credit strategies therefore strongly improves diversification.
Importantly, by systematically harvesting factor premiums, factor strategies can be expected to deliver both a higher risk-adjusted return and a higher return on capital than passive credit portfolios. Numerous academic studies on various asset classes, including stocks and bonds, have shown that factor portfolios deliver superior risk-adjusted returns over a full investment cycle, compared to a portfolio that passively tracks the market index.
Moreover, explicitly integrating insurance capital requirements into factor credit strategies can further enhance the return on capital. In our research, we found a strong positive correlation between the Solvency Capital Ratio and credit volatility. Therefore, a factor portfolio not only generates a higher return to volatility ratio (i.e. Sharpe ratio) than the market, but also a higher return to capital ratio.
By tilting a portfolio towards bonds that score well with regard to factors, and avoiding bonds that have poor factor scores, investors can therefore construct a portfolio that generates a higher risk-adjusted return and a higher return on capital than a portfolio that passively tracks the market.
Robeco’s multi-factor credit strategies offer exposure to the low-risk, quality, value, momentum and size factors. We apply enhanced definitions for each factor. Compared to more generic factor definitions, such as those typically used in academic research, these enhanced definitions lead to higher risk-adjusted returns. Our strategies also explicitly take liquidity, transaction costs and turnover into account, and construct well-diversified portfolios with a better sustainability profile than the index. They therefore offer more realistic expectations for attainable improvements in the return-on-capital ratio.
Ultimately, our factor credit strategies provide a cost-efficient building block for insurers. These strategies can also be tailored to address specific requirements, for example when insurers wish to match a liability cashflow stream or aim for a certain level of income from a low-turnover buy-and-maintain credit portfolio.
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