“Isn’t value investing more of an equity market concept?”
The short answer is no. While it’s a legitimate question (and one we’ve gotten quite accustomed to hearing), the reality is that both equity and fixed income market participants are often drawn to “cheap” assets by the allure of enhanced excess return potential. Here is some of my team’s latest thinking on value investing and why we think it’s relevant in credit markets.
What exactly is “value” investing in credit markets anyway?
For years, many fixed income investors have adhered to pretty loose definitions of what constitutes an overvalued (“expensive”) or undervalued (“cheap”) credit asset, typically based on whether its option-adjusted-spread is wide or tight versus a given risk-free asset (e.g., US Treasuries).
Our investment framework goes a step further with a more nuanced approach to the notion of “value” in corporate credit markets. We follow a rules-based, fundamentally driven factor methodology focusing on securities that we believe are trading cheap relative to their probability of default, other comparable issuers, or certain technical market forces. This way, “value” doesn’t simply refer to the lowest-priced, widest-spread, or lowest-rated bonds.
How have the performance results been?
Unlike value investors trying in vain to outperform broad equity indices through mean reversion, fixed income has been a markedly different story. Mean-reversion factors were among the best-performing factors in US corporate credit markets over the past decade. Value investing in particular was a material outperformer in 2020, extending its post-2008 dominance over traditional bond market exposures and most other fixed income factors (Figure 1).
Why has value fared so well in credit markets over the past decade?
In our view, there are some powerful structural dynamics at play that have provided a supportive backdrop for the value style of fixed income investing:
- A fairly benign credit-default environment (characterized by low realized default rates), with credit valuations more or less overcompensating for perceived default risk;
- Temporary liquidity-driven market dislocations, which can create attractive opportunities for value-oriented credit strategies to step in as stopgap liquidity providers; and
- The highly accommodative actions taken by global government policymakers, which have depressed sovereign yields and lured investor capital to opportunities in higher-yielding credit markets.
In our judgment, fixed income clients and active managers seeking greater diversification and return potential can continue to benefit from having value-style credit strategies in their toolkit. More broadly, we think it’s time for allocators to rethink fixed income investing and pursue more creative, differentiated solutions — including (but not limited to) value investing in credit. Such allocations can be highly effective complements to more traditional bond allocations.
As many investors reassess their fixed income portfolios in the face of today’s historically low yields and challenged forward-return prospects, we believe a factor-based investing playbook can add an important dimension to portfolio construction and management. To learn more, see Bringing the X “factor” to fixed income.