Corporate Bond Portfolios Research Articles

ESG criteria and the credit risk of corporate bond portfolios

Demand for sustainable fixed-income investment solutions is surging but there is hardly research on the impact of sustainability on the risk characteristics of fixed-income portfolios. This study examines the impact of sustainability on the credit risk exposure of corporate bond portfolios between 2013 and 2020 by analyzing the returns of sustainable and non-sustainable portfolios using two different asset pricing models and environmental, social, and governance (ESG) ratings from different providers. Controlling for a set of portfolio characteristics, our results show that sustainable portfolios are significantly less exposed to credit risk than their non-sustainable peer portfolios. This finding implies that considering ESG criteria in portfolio management is a suitable means to systematically manage credit risk. Being the first study to investigate the relationship between sustainability and credit risk on a portfolio level, this study contributes to the understanding of the effects of ESG criteria in portfolio management and provides academics and investment professionals with valuable insights.

Green Parity and the Decarbonization of Corporate Bond Portfolios

This study explores the incorporation of climate change into fixed income investment. We investigate the cost of decarbonization and the selection of Sustainable Investment strategies in portfolio construction, providing a comprehensive analytical framework. Employing a passive management style and through empirical analysis, we assess the tradeoff between decarbonization and the associated cost in terms of benchmark deviation for a corporate bond portfolio. We also propose an innovative strategy called “Green Parity,” which helps to improve traditional approaches to decarbonization. Our results challenge the common belief that pursuing decarbonization targets inevitably compromises risk-return outcomes.

The cross-section of Chinese corporate bond returns

We study the relation between bond characteristics and corporate bond returns in China's two distinct and segmented bond markets—the interbank market and the exchange market—with a large cross-sectional dataset of 8318 corporate bonds from January 2010 to December 2022. Corporate bonds with large sizes, long maturities, old ages, poor credit ratings and large Amihud illiquidity earn high monthly returns in the interbank market. The return predictive patterns of bond size, time to maturity, and credit rating are similar in the exchange market, but bond age and Amihud illiquidity predict returns in the opposite direction, implying market segmentation. We construct two factors based on credit rating and Amihud illiquidity to represent the common risk of corporate bonds—credit risk and liquidity risk—and use the Hansen-Jagannathan distance to evaluate the performances of factors in explaining the returns of corporate bond portfolios. We find that the two characteristic-based factors help reduce the model specification errors of the five factors in Fama and French (1993).

A One-Factor Model of Corporate Bond Premia

A one-factor model based on long-run consumption growth explains the risk premiums on corporate bond portfolios sorted on credit rating, credit spreads, downside risk, idiosyncratic volatility, long-term reversals, maturity, and sensitivity to the financial intermediary capital factor. The estimated risk-aversion coefficient is lower when we use the consumption growth of wealthy households over a longer horizon as a risk factor, and a model with a 20-quarter horizon yields a risk-aversion coefficient of 15, a value similar to the one estimated from equity portfolios. This paper was accepted by Bruno Biais, finance. Funding: Y. Nozawa acknowledges funding from the Center for Investing at the Hong Kong University and Science and Technology. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.4784 .

Market-wide illiquidity and the distribution of non-parametric stochastic discount factors

Employing out-of-sample non-parametric estimation techniques, we show that market-wide liquidity risk matters for asset pricing independently of the specific functional form of the stochastic discount factor (SDF) and, therefore, of the asset pricing model specification. Market-wide illiquidity significantly affects the distribution of the SDF. Specifically, it boosts up the volatility of the SDF, causing minor effects on higher moments of its distribution. This finding is robust to the use of different sets of test assets in the estimation of the SDF, including equity and corporate bond portfolios, and the use of a high-dimensional data estimation procedure.

The income bond puzzle

The income bond puzzle

Which uncertainty measures matter for the cross-section of corporate bond returns? Evidence from the U.S. during 1973–2020

I examine which economic uncertainty measures matter for the cross-section of corporate bond returns using 40 corporate bond portfolios for a long period from 1973 to 2020. Out of a comprehensive list of 24 economic uncertainty measures, I find that tax policy uncertainty is the most significant both economically and statistically. I also find that measures that are documented as significantly priced factors – VIX, EPU, and economic uncertainty measures (Jurado et al., 2015) – are not robust to the long sample period and my empirical approach to rigorously estimate uncertainty shocks.

An Empirical Analysis of the Benefits of Corporate Bond Portfolio Optimization in the Presence of Duration Constraints

This article analyzes the out-of-sample performance of portfolio optimization models in the US corporate bond universe. In our empirical study, we measure the benefits of naive diversification and find that it eventually reaches a limit as the number of bonds increases. Also, we observe substantial improvements in the risk-adjusted performance of scientific portfolio constructions when compared to simple barbell strategies for the same given duration. When duration constraints are relaxed, we find that both naively and scientifically diversified portfolios outperform cap-weighted benchmarks in terms of Sharpe ratio.

Reversal effect and corporate bond pricing in China

This paper documents significant price reversal in Chinese corporate bonds using transaction data from 2008 to 2018. We contribute to the existing literature by constructing a reversal factor and proposing a new corporate bond pricing model. Corporate bonds generating lower returns in the past months outperform those generating higher past returns. The reversal profits are strongest in portfolios with around 9-month formation period and disappear when the formation period reaches 12 months. After controlling for bond rating, maturity, turnover, and trading volume, the reversal effects remain significant. We construct a reversal factor and propose a four-factor model by incorporating the new factor into the default-term two-factor bond pricing model plus the bond market factor. The proposed four-factor model captures systematic risk and reversal effect well and makes a significant marginal contribution to explaining the excess return of corporate bond portfolios.

Practical Applications of Implementing Value and Momentum Strategies in Credit Portfolios

In <b>Implementing Value and Momentum Strategies in Credit Portfolios</b>, from the Quantitative Special Issue 2021 of <b><i>The Journal of Portfolio Management</i></b>, authors <b>Simon Polbennikov</b>, <b>Albert Desclée</b>, and <b>Mathieu Dubois</b> (all at <b>Barclays</b>) explore the strategy of applying value and momentum signals to corporate bond portfolios. The authors conducted an analysis to determine whether style factor investing is a suitable strategy for investors. Because data for credit portfolios managed with systematic styles were unavailable, the authors built a simulation of portfolios net of transaction costs between 2007 and 2020. They then applied a relative value strategy and an equity momentum strategy to the simulated data. Concluding that each signal resulted in higher returns than the benchmark index, they then applied the strategies in an equally weighted composite form. The authors ultimately concluded that, net of rebalancing costs, using such styles in strategy portfolios can result in considerable returns compared to the benchmark index. However, successfully implementing them in a portfolio also requires turnover controls, identification of actively traded and liquid securities, and strategic portfolio construction relative to a benchmark. <b>TOPICS:</b>Performance measurement, portfolio construction, simulations, style investing

Hybrid Portfolios of Indian Corporate Debt and Government Securities: A Comparative Study

A Model is constructed to evaluate the performance of hybrid portfolios of GSecs and Corporate Bonds. Historical data is utilized to compute the performance of three hybrid investment portfolios. These are six G-Secs (short, medium and long term) in combination with one Mutual Fund Corporate Bond Scheme, allocated with different weights into each of the three hybrid portfolios. The paper presents risk and return performance of the three portfolios in absolute terms and also against a single government security which may be regarded as a tentative benchmark. Such hybrid debt portfolios may be of interest to various categories of investors.

Can an equity structure dominate the risk-return profile of corporate bonds?

In a very low interest rate and tight credit spread environment, institutional investors look for alternatives to enhance their fixed income portfolios whilst maintaining their risk profile. Some have devised hedge funds as a solution to improve return at comparable risk levels. More recently, some authors show that appropriate optional strategies could offer better risk-return profiles than hedge funds. This paper proposes a synthetic equity derivative structure that mimics the cash flow behaviour of a corporate bond portfolio. Both alternatives are empirically compared, balancing their yield with their level of risk, and integrating the probability of default. In the case of the high-rating class, our results show that the derivative structure offers a better “spread-default” profile than that of corporate bonds. This may have interesting implications for insurers and pension funds that seek to invest a substantial fraction of their portfolio in high-grade fixed income assets and is consistent with the focus of liability-driven investors on yearly cash flow requirements.

Evaluation of market risk associated with hedging a credit derivative portfolio

Hedging a credit portfolio using single-name credit default swap (CDS) is affected by low liquidity and high spread volatility, which induces continuous changes in a portfolio mark-to-market. As an alternative, we consider hedging a derivative portfolio by taking a contrary position in a credit index, evaluating the empirical market risk that remains after such hedge. We perform three different hedging exercises: for single-names, for sectorial portfolios and for regional portfolios. We implement least squares hedging as a benchmark, and compare its efficiency with a hedge ratio estimated under the RiskMetrics exponentially moving average (EWMA) specification for time varying second order moments, as well as with the hedge ratio obtained from a bivariate GARCH model for the portfolio and the credit index used as a hedge. Over the 2007–2012 period, we find a high hedging efficiency for regional portfolios (Europe, North America and Japan), as well as for a global portfolio, which is back at pre-crisis levels. The EWMA hedge is slightly more efficient than the least-squares hedge, while the GARCH hedge does not improve hedging efficiency. Hedging efficiency is not as high for sectorial credit portfolios from Europe and North America, due to their more important idiosyncratic component. Taking into account the quality of the credit counterpart improves the effectiveness of the hedge, although it requires using less liquid credit indices, with higher transaction costs. This hedging strategy becomes much more complex if firms in the portfolio have a large idiosyncratic component. The efficiency of the hedge is higher when liquidity risk and systematic risk are high, or when the term structure is flat. We also provide evidence suggesting that credit indices can also offer a moderately efficient hedge for corporate bond portfolios, which we have examined with a reduced sample of firms over 2006–2018.

Quantitative Easing and Nature Loss: Exploring Nature-Related Financial Risks and Impacts in the European Central Bank's Corporate Bond Portfolio

Quantitative Easing and Nature Loss: Exploring Nature-Related Financial Risks and Impacts in the European Central Bank's Corporate Bond Portfolio

Implementing Value and Momentum Strategies in Credit Portfolios

Implementing quantitative signals in a corporate bond portfolio can be challenging owing to high transaction costs, large variations of liquidity across individual bonds, and the requirement to follow a benchmark index. The authors design realistic simulations that illustrate the performance and characteristics of quantitatively managed portfolios of liquid corporate bonds with attractive value and momentum characteristics. They show how to implement a turnover budget to explicitly control rebalancing volumes. Such realistic strategy portfolios have significantly outperformed the Bloomberg Barclays US Corporate Bond Index after transaction costs, with information ratios above 1 since 2007. The results of this study support the case for style factor investing in credit. TOPICS:Performance measurement, portfolio construction, simulations, style investing Key Findings ▪ Relative value and equity momentum styles can be successfully implemented in corporate bond portfolios net of transaction costs. ▪ We explain how to overcome challenges related to identifying liquid tradable securities with attractive value and momentum characteristics, keeping transaction costs in check, and following a benchmark index at the same time. ▪ Index-tracking portfolios that match key exposures of the US Corporate index, but also overweight bonds with attractive value and momentum characteristics, significantly outperformed the benchmark index after transaction costs, with information ratios above 1 since 2007.

Hunt-for-Duration in the Corporate Bond Market

This paper examines the duration hedging behavior in the corporate bond market by studying the investment decisions of life insurance companies, the largest institutional investor in this market. Using security-level data on insurers' bond holdings, I find that life insurers are tilting their corporate bond portfolios towards bonds with higher duration as the interest rates decrease to historical lows since the 2008 financial crisis. This hunt-for-duration behavior is due to life insurers' interest rate risk hedging to ensure better duration matching between their assets and liabilities. I further show that hunt-for-duration by life insurers can drive overpricing of corporate bonds when a negative monetary policy surprise hits.

Cross-sectional Examination of the Corporate Bond Market Performance - The Rise of the Momentum and Contrarian Unidentified Factor Mimicking Corporate Bond Portfolios!

We examine momentum and reversal anomalies in corporate bond returns at the firm-level employing a novel dataset, SoKat Credit, comprising bonds of 323 of the largest and liquid companies over the period from 2002 to 2020. Our study documents significant short-term reversal in the cross-sectional of corporate bond returns concentrated at the one week interval with annualized returns on the zero investment long-short portfolio of 9.9%. We also document company-level momentum spillover effect into corporate bond returns when sorting on past equity returns, that is, our “bond-stock” strategy, which delivers annualized return of 5.0% is statistically significant and robust baring the usual suspects of caveats.

A One-Factor Model of Corporate Bond Premia

A one-factor model based on long-run consumption growth explains the risk premiums on corporate bond portfolios sorted on credit rating, credit spreads, downside risk, idiosyncratic volatility, long-term reversals, maturity, and sensitivity to the financial intermediary capital factor. The estimated risk-aversion coefficient is lower when we use the consumption growth of wealthy households over a longer horizon as a risk factor, and a model with a 20-quarter horizon yields a risk-aversion coefficient of 15, a value similar to the one estimated from equity portfolios.

ESG in Global Corporate Bonds: The Analysis Behind the Hype

Both large institutional and individual retail investors are increasingly demanding that the stewards of their savings demonstrate consideration of environmental, social, and governance (ESG) externalities in their decision making. This study asks how different ESG scores are from traditional agency credit ratings. Are E, S, and G scores correlated? Most importantly, can ESG scores enhance the investment process? Can an active, ESG-tilted corporate bond portfolio strategy generate superior performance versus a relevant benchmark that does not explicitly take ESG scores into account? The authors conclude that ESG scores can be used to enhance portfolio outcomes via lower drawdowns, reduced portfolio volatility, and, in some cases, even marginally increased risk-adjusted returns. Their backtesting suggests that E, S, and G scores are not related to one another and that ESG scores are additive to traditional credit ratings; the contingent liabilities related to ESG issues are not necessarily factored into rating agencies’ assigned credit ratings. TOPIC:ESG investing Key Findings • ESG scores can be used to enhance fixed-income portfolio outcomes via lower drawdowns, reduced portfolio volatility, and, in some cases, even marginally increased risk-adjusted returns. • Cross-sectional correlations show that E, S, and G scores are not related to one another. • ESG scores are additive to traditional credit ratings. In other words, the contingent liabilities related to ESG issues are not necessarily factored into the rating agencies’ assigned credit ratings.

Climate Financial Risks: Assessing Convergence, Exploring Diversity

Climate risks are now fully recognized as financial risks by asset managers, investors, central banks, and financial supervisors. As a result, the integration of climate risk metrics into risk management processes is moving up agendas worldwide. In that context, a rapidly growing number of market participants and financial authorities are exploring which metrics to use to capture climate risks, and to what extent the use of different metrics delivers heterogeneous results. This discussion note takes a first step in analyzing the convergence in assessments of climate-related transition risks across metrics providers, based on the ECB corporate bond portfolio. Our findings show that firms’ risk assessments across metrics are fairly heterogeneous but tend to converge on which firms are most and least exposed to transition risks. We also show that the temperature targets and time horizons underlying the metrics matter, although moderately, for the assessment of firms’ risk exposure and that providers using similar methodologies tend to deliver more convergent assessments. Our findings contribute to the growing recognition that asset managers, investors, central banks and financial supervisors can and should use available metrics to better integrate climate risks into risk management and financial supervision.