Shielding factor portfolios from credit downgrades and defaults
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Higher Sharpe ratio and reduced downside risk via enhanced factors
Improved downside risk management in portfolio construction
Multi-factor strategies well fitted to mitigate downgrades and defaults
Preventing downside risk is paramount when investing in corporate bonds, as the loss on a bond investment can be multiple times larger than its upside potential. Typical events that cause price declines are downgrades and defaults. Our research shows that a naïve academic implementation of a factor strategy leads to increased downside risk.1
Robeco’s multi-factorcredit strategies use two main methods to effectively bring down downgrade and default rates. First, by using enhanced factor definitions, we avoid the risks to which investors in generic factor definitions are unnecessarily exposed. Second, our proprietary portfolio construction algorithm manages risks and identifies high-risk names with the goal to effectively reduce the portfolio downgrade and default rates below benchmark levels. As a result, there typically is a reduction in downside risk in our portfolios, with the expectation that risk-adjusted returns improve.
The effect of downgrades and defaults on corporate bond returns
To investigate corporate bond returns around downgrades or defaults, we carried out an event study over the period 1994 to 2020. The finding was that, one year prior to being downgraded, the average bond underperformed its benchmark by 12%. For defaults, this underperformance was even greater, at 47%. To improve the return of a corporate bond strategy, it is therefore paramount to avoid having these bonds in the portfolio well in advance of a downgrade or default event.
Interestingly, the analysis also showed that a downgraded bond consistently outperforms the market after its initial decline, implying that the market overreacts to downgrades. This overreaction is particularly strong for downgrades from investment grade to high yield, also known as ‘fallen angels’.2
Downgrades and defaults in credit factor portfolios
Robeco’s multi-factor strategies in investment grade and high yield credits target balanced exposure to factors such as value, momentum, low-risk/quality and size. Generic versions of these factors have been documented in our academic work, showing that factor portfolios have better risk-adjusted returns than the overall credit market. These generic factors are defined such that they are applicable broadly across all corporate bonds as they use only corporate bond information.
Within our live investment strategies, we extend the generic factor definitions by using more sophisticated techniques and by using accounting and equity data to derive enhanced definitions. By avoiding unrewarded risks that are present in the generic definitions, these enhanced factors have previously been shown to have significantly higher risk-adjusted returns than the generic factors.
To analyze the probability of downgrade and default events in factor portfolios, we count the number of times a bond in a factor portfolio has been downgraded or has defaulted within 12 months of the establishment of the portfolio. We do this for the factor portfolios constructed using the academic approach in Houweling and Van Zundert (2017), where a factor portfolio invests in all bonds that are ranked in the top 10% of the investment universe, as sorted on that factor. The results are shown in Figure 1; defaults in investment grade are not shown, as there are too few observations to draw proper conclusions. We find that, for all factors, our enhanced factor definitions (the grey bars in the chart) effectively decrease the downgrade as well as the default rates compared to the generic definitions (the blue bars).
Figure 1 | 12-month-ahead downgrade and default rates