by Christoph Schon, CFA, CIPM
Much of the recent market turmoil has been driven by worries about debt. Granted, debt is not a bad thing, per se. But the fact that many households and corporations must now borrow extensively just to stay afloat is a major concern. This is reflected in both wider credit spreads and the fact that the shares of heavily leveraged companies have significantly underperformed the overall market. While the large-scale bond-buying by central banks has led to both lower credit-risk premia and higher share prices, those same leveraged companies have benefitted to only a limited degree so far.
In our recent blog post on The top 10 cross-asset correlations to watch, we highlighted the close relationship between credit spreads and share prices in the current crisis. We noted that a large part of the stock-market sell-off in February and March was driven by concerns about the ability of corporate issuers to repay debt accumulated over the forced lockdown periods. The extensive purchases of corporate debt by the world’s largest central banks alleviated some of those fears, and credit-risk premia (represented by the inverted green line in the chart below) came down again, alongside rising share prices.
US share prices versus USD corporate-bond spreads
Sources: Qontigo, Axioma Fixed Income Spread Curves
The impact of heightened solvency concerns and increased borrowing costs was particularly strong on “leveraged” firms with a high level of debt relative to their total assets and common equity. This was reflected in the return of the Leverage factor from Axioma’s US4 short-horizon fundamental equity risk model, depicted by the blue line in the graph below.
US Leverage factor cumulative return vs USD BBB credit spread 2020 year-to-date
Sources: Qontigo, Axioma Fixed Income Spread Curves
As the style-factor return is in excess of the overall market, it indicates that companies with a positive exposure to this factor (i.e., those with more debt) would have suffered additional losses relative to those with lower or no leverage, as credit-risk premia increased. However, this underperformance was not reversed in the subsequent recovery. In other words, the support supplied by the Federal Reserve’s purchases of corporate debt did not provide any visible additional benefits to heavily indebted companies, at least not on top of the effect it had on the overall market.
Looking at previous times of market distress, we find similar patterns for the Leverage factor and credit spreads, although the evidence is not entirely conclusive. In the first example below, we examine the two most recent crises—the Eurozone debt crisis in 2011/12 and the Chinese stock-market turbulence in late 2015. We see that the Leverage factor moved in almost perfect unison with the (inverted) credit spread in the first instance, initially producing negative returns as spreads widened, but then making a full recovery as the debt concerns subsided. In the Chinese crisis, on the other hand, we observe the same pattern as in the current environment, with the Leverage return remaining around the new lower level after the initial sell-off.
US Leverage factor cumulative return vs USD BBB credit spread 2011-2017
Sources: Qontigo, Axioma Fixed Income Spread Curves
Going back to the early 2000s, we see the same interactions playing out. During the 2002 stock-market correction following the burst of the dotcom bubble, credit-risk premia and the Leverage factor moved in tandem, with the latter seeming to have captured only the downside in the global financial crisis.
US Leverage factor cumulative return vs USD BBB credit spread 2002-2010
Sources: Qontigo, Axioma Fixed Income Spread Curves
Unlike factor strategies that carry a well-documented premium—such as Momentum, Volatility, Size, and Profitability—Leverage is not usually considered a “rewarded” factor. While its performance can change with varying levels of interest rates and corporate borrowing costs, it would normally be expected to revert toward its mean. The chart below shows the cumulative performance of the US leverage factor over the entire 20-year period. It confirms the notion that, most of the time, the performance of the factor is indeed mean-reverting. However, it also highlights the substantial downside risk in periods of tight credit conditions, such as the global financial crisis or the current pandemic.
US leverage cumulative return since 2000
Source: Qontigo
In both of those instances, central-bank intervention seemed to have improved the overall stability of financial markets by easing borrowing conditions for the economy as a whole—but there appeared to be no additional benefit for companies with already high debt burdens. Therefore, betting on companies with heavy debt loads—in the hope that quantitative easing may alleviate their condition—appears to be a dangerous gamble.
