Reach for Safety

Abstract

In the corporate bond market, investor propensity to reach for yield creates an opportunity for factor-based investors to “reach for safety” following an economic intuition that parallels low-risk factor investing in equities. Given this insight, we motivate a measure of credit safety based on the Merton (1974) distance-to-default variable, which we use to define quality and value factors. We demonstrate that both factors help explain the cross-section of corporate bond returns in an uncorrelated and complementary manner. Since these factors have performed particularly well in their bottom quintiles, we demonstrate how they can be used as screens within long-only portfolios. In addition, we show how incorporating our quality and value insights in a long-only optimization setup can generate significant outperformance net of estimated transaction costs versus traditional value-weighted market portfolios.

Keywords: Asset Pricing, Factor-Based Investing, Fixed Income