Research Affiliates strives to develop straightforward investment strategies that harness the primary drivers of portfolio results. In this article, Shane Shepherd recaps empirical bond market research on credit, leverage, and cash flow risk, and summarizes the evidence for mean reversion in spreads. He also shows how these research findings shaped the design of a strategy index for corporate bonds.
The researchers at our firm have a distinctive way of thinking about capital markets and investment strategies. We focus on understanding the primary drivers of risk and return—often discovering, in the process, how the empirical facts differ from theoretical predictions—and we favor building uncomplicated investment solutions. In the arena of fixed income, for example, we have re-examined the relationships between historical returns and credit, leverage, and cash flow risk, and investigated the price impact of mean reversion in credit spreads. We marvel at the engineering refinements in other firms’ products, but we prefer to design simple, see-through strategies that work reliably. We strongly believe that solutions without a lot of moving parts and hidden assumptions are most robust.
These principles—realism in research and simplicity in design—guide all our work in asset allocation, equities, fixed income, and alternative assets. This issue illustrates the Research Affiliates approach by discussing the practical significance of risk and return characteristics we’ve identified in the course of our bond market explorations.
Recent Research on Corporate Bonds
Strategy indices, commonly known as Smart Beta strategies, are gaining broad acceptance among equity investors. They are less well known in the bond markets. However, traditional passive investing in bonds has disadvantages similar to those that are now widely acknowledged in equities. Established bond indices weight constituents on the basis of their market values. This effectively means that the companies which issue the most debt are given the greatest allocations.
But why would investors want to increase their exposure to the biggest debtors? Frequently, a large amount of debt issuance goes hand in hand with increased risk. Our research suggests that these risk exposures often do not provide a satisfactory return premium. To avoid this poor risk–return trade-off, it seems desirable to weight corporate bond index constituents on some basis other than price.
What sort of risks do investors take on as debt issuance increases? Certainly higher debt levels are associated with declining credit ratings. But credit ratings are an imperfect measure of risk, slow to be revised and not always reflective of the debt burden for a company. More focused metrics for our purposes are fundamental characteristics of a company that directly measure their debt service capacity: leverage and cash flow coverage. All else equal, as debt rises relative to the economic size of the corporation, firms will show rising leverage (debt relative to assets) and declining cash flow coverage (cash flow relative to debt).
Our research shows that investors took on additional risk yet were not rewarded for accepting greater leverage over the past 17 years. Table 1 provides risk and return statistics for bonds sorted into debt-to-long term asset quartiles.1 Higher leverage comes with higher risk, any way you measure it—by volatility of returns, higher credit spreads, and greater incidence of downgrades. But the bonds of highly leveraged companies have lower Sharpe ratios, or risk-adjusted returns, than the bonds of companies with low debt ratios. This is driven not only by rising volatility (to be expected) but also by declining returns.