This page includes sophisticated financial research and educational information that is intended only for investment professionals and other knowledgeable institutional investors who are capable of evaluating investment risks and making their own investment decisions. It should not be interpreted as investment advice or as a recommendation of an particular security, strategy or investment product.
Credit Risk Premium
Corporate bonds are an important component of many fixed income portfolios because they offer exposure to the credit risk premium—an additional source of returns beyond those from default-free government bonds. Yet though it seems intuitive to expect a higher return for bearing corporate default risk, past research has found limited evidence to support it. Why the disconnect? Is there a premium for investing in credit, and how large has it been?
Research on this topic has traditionally looked at the simple difference between long-term corporate bond returns and long-term government bond returns. But this simple difference misses a key fact: corporate bonds tend to have lower interest rate durations than government bonds. Correcting for this, we find strong evidence, across many decades and markets, of a credit risk premium whose risk-adjusted returns are in line with other major market risk premia.
Importantly for investors, we find the credit risk premium to be different from the commonly known term (or bond) premium and equity risk premium. That means the addition of corporate bonds—a source of return with unique risk characteristics—may help investors build more efficient portfolios.
Factors in Fixed Income Markets
Momentum, value and other factors exist not only in
equities—we also find evidence of their efficacy in government and corporate
bonds. The notion of each factor in bonds shares much with its counterparts in
Of course, the implementation will differ somewhat. Value in bonds aims to distinguish cheap versus expensive bonds by using a fundamental anchor to measure against, but the specific metrics differ from those used for equities. In government bonds, for example, value can use yield-based measures: observed yield relative to an “anchor” of inflation expectations. The intuition for corporates is similar: value might consider the credit spread (rather than pure yield) relative to a fundamental anchor such as default expectations.
Factors in fixed income markets have decades of evidence to support their inclusion in many portfolios. These factors also have delivered returns that are diversifying to one another, suggesting a multi-factor approach may lead to even better results.
Active Systematic Fixed Income Managers Invest?
Given multiple systematic sources of returns in fixed income
markets, which do active bond managers actually harvest?
The answer varies across categories and from manager to manager, but we find exposure to credit tends to explain a lot. Taking the Core-Plus bond category as an example, we find about 95 percent of active returns can be attributed to exposure to high-yield credit over the past 10 years.
What this means for many investors is that seemingly diversified allocations across multiple fixed income funds might result in one active bet on credit and much smaller exposures, if any, on other factors such as value or momentum—ones that may be as diversifying and have as much evidence supporting their efficacy. In our view, these investors may be missing out on an opportunity to outperform.
April 1, 2016
A disciplined, systematic approach to over/underweight securities based on well-known factors, or styles, such as value, momentum, carry and defensive (sometimes called “quality”), can offer alternative sources of outperformance not only within equities, where these ideas have long been studied and applied, but also within fixed income markets.Read more
This information is for informational purposes only and not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
Past performance is not a guarantee of future results. Diversification does not eliminate the risk of experiencing investment loss. Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH, BUT NOT ALL, ARE DESCRIBED HEREIN. NO REPRESENTATION IS BEING MADE THAT ANY FUND OR ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN HEREIN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY REALIZED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS THAT CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS, ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Discounting factors may be applied to reduce suspected anomalies. This backtest’s return, for this period, may vary depending on the date it is run.