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Blog Posts — April 20, 2021

Four Reasons why Value Investing works in Fixed Income

by Christoph Schon, CFA, CIPM

Much has been written about the spectacular comeback of Value stocks. But has this also been reflected in the credit market? The steep rise of the Value factor from the Axioma Factor-based Fixed Income Risk Model[1] over the past 14 months seems to suggest that the answer is yes. In this blog post, we explore some of the reasons Value investing has worked so well in fixed income—not just in recent months, but for many years—and may continue to do so in the future.

The chart below shows the cumulative returns of the Global Market Intercept and Global Value factors from the Axioma FFIRM since 2007. The factor returns were estimated from a cross-sectional regression of issuer credit-spread returns. All issuer curves have an exposure of 1 the Market factor, which is depicted in blue. It approximately tracks the overall behavior of global credit-spread levels and has been following the ups and downs of the global financial crisis, the Eurozone sovereign-debt crisis, the Chinese stock-market turbulence, and the COVID-19 pandemic. But there appears to be no discernable trend.

Cumulative global credit factor returns since 2007

Source: Axioma Factor-Based Fixed Income Risk Model

This contrasts with the Value factor (depicted in green), which seems to have been on a steady upward trajectory over the past 14 years. The factor is designed to capture excess returns over the Global Market factor of issuers whose bonds appear to be mispriced relative to companies with the same rating, issuing in the same currency. Exposure to the factor is defined as the difference in log spreads between the issuer curve and the corresponding rating/currency cluster curve multiplied by minus one. Companies with a yield premium above the peer-group average will, consequently, have a negative sensitivity. In monetary space, this negative exposure is then multiplied by the bond’s sensitivity of minus one times duration times spread, so that a positive factor return translates into a price increase. “Cheap” bonds with wider spreads would, therefore, benefit from a rise in the factor, while “expensive” issues with spreads below the average would underperform.

1. Reversion to the mean

The main premise behind this strategy is, of course, that the spreads of those “mispriced” securities will revert toward the average of the peer group. In our recent whitepaper Do Sectors Matter in Fixed Income? Less Than You May Think…, we noted that the sensitivity to overall market movements and the creditworthiness of a company were more significant drivers of corporate bond returns than, for example, sectors or countries. Provided that a rating appropriately captures an issuer’s ability to repay its debts, it seems reasonable to assume that the yield premium should primarily reflect the associated repayment risk.

2. Playing catchup

If this mean reversion is further coupled with a strong trend in the overall market, some spreads will have to travel a longer distance to catch up with the peer group than others. For instance, when borrowing conditions deteriorate and credit-risk premia expand, the spreads of those issuers, who had already been trading above their reference group, might widen less, which means that their losses would be smaller than the market average. Those same companies would also outperform in an environment of tightening spreads, as their yield premia would have to fall by a much larger amount in order to close the gap.

3. Fallen angels bouncing back

This phenomenon is likely to be even more pronounced for issuers, who have recently experienced a reduction in their credit rating. Especially when a company loses the coveted “investment grade” rating, funds with a mandate that does not allow them to invest in high-yield or “speculative grade” instruments will be forced to liquidate their holdings in the respective securities. One such example is the American automobile manufacturer Ford, which was downgraded from BBB-, the lowest investment grade rating, to BB+ by S&P Global Ratings on March 25, 2020.

5-year credit spreads over USD risk-free rate

Source: Axioma Fixed Income Spread Curves

The chart above shows the 5-year credit-spread level of Ford’s dollar-denominated senior debt versus the corresponding averages of USD securities with Risk Entity Ratings[2] between BBB3 and BB2 from all sectors and regions. We see at the left of the chart that even before the downgrade on March 25—when Ford still carried a BBB- rating from S&P and a Ba1 rating from Moody’s—the company’s debt already traded at a level more consistent with a BB2 grade. What is also interesting is that its yield premium had already begun to expand disproportionally against the market average before the announcement of the rating change, which indicates that many funds had already been selling their holdings in anticipation of that change. On the contrary, the spread actually tightened again by 300 basis points in the four days after the announcement.

4. (With a little) help from the central banks

Another important contributing factor to Ford’s swift recovery may have been the fact that the Federal Reserve Bank announced on April 9, 2020, that it would include lower-rated debt in its asset-purchasing program[3]. This could be accomplished either indirectly through buying high-yield ETFs or directly by acquiring securities from companies, which had been considered investment grade on March 22, and would include a large part of Ford’s outstanding debt. In fact, on the day of the announcement, Ford’s spread tightened another 2.3 percentage points, shrinking the gap over the BB2 average from around 240 to under 60 basis points. Once the Fed actually began buying high-yield securities in mid-May, credit markets got another boost, and Ford once more started to close gap—which at that time had expanded again—all the way down to less than 20 basis points at the time of writing.

Cumulative global credit factor returns 2020/21

Source: Axioma Factor-Based Fixed Income Risk Model

So far this year, the fixed-income Value factor is up 1.2%, despite overall spread levels moving mostly sideways. Will it maintain its upward momentum in the near future? We believe that the chances are good, as the underlying premises are likely to remain valid. We noted that the main concern for fixed-income investors is an issuer’s ability to repay its debt and that the yield pick-up over a risk-free investment should reflect that. If that premium is too far from the average of comparable, alternative instruments with the same credit quality, it should gravitate back toward that mean. That includes fallen angels, whose spreads may have surged too far due the forced selling surrounding the downgrade—especially as central bankers around the world appear to remain keen to stress that they are in no hurry to end their asset-purchasing programs. And last, but not least, the most recent performance of the Value factor has demonstrated that it can generate positive returns in both upward and downward markets, which is further supported by historical evidence.

[1] For more information on the Axioma Factor-based Fixed Income Risk Model, see our whitepaper Bonds have style, too: A new model for capturing fixed-income risk premia…and much more.

[2] The Risk Entity Rating used for the Axioma Fixed Income Spread Curves is the lowest of issuer (or bond) ratings from Fitch Ratings, Moody’s Investors Service, and S&P Global Ratings.

[3] The European Central Bank followed suit with a similar commitment to accept sub-investment debt as collateral in its funding facilities, as long as the securities were rated at least BBB- as of April 7.