Credit Default Risk and Leveraged Small Value Equity Returns
Investor fears about the impact of rising rates on equities are probably overstated. But the world is full of other risks that could cause a drop in equity prices. We believe the most significant risk facing leveraged small value equities in the US and Europe is the risk of credit default. (Japan’s bankruptcy rate is so low that default risk is largely irrelevant.)
Every few years, fear strikes the high-yield market. The high-yield spread spikes. New issuance of high-yield bonds drops. During these periods, investors flee from leveraged equities, scared that these companies will be unable to refinance their debt and that the risk of bankruptcy is significantly higher than they’d anticipated.
We wanted to study this phenomenon better so we could both understand and communicate the risks of our strategy as clearly as possible. We looked at the relationship between default risk and returns on leveraged small value equities back to 1965 in the United States (there is no high-yield market in Japan and there are therefore no high-yield driven crises. We will share a separate analysis on Europe in a few weeks.).*
The best way to measure default risk in the market is the difference between the yield of low-grade corporate bonds and the yield of investment-grade corporate bonds. This difference is known as the high-yield spread. The narrowness or wideness of this spread reflects the price investors demand to hold default risk.
Since 1965, there have been 11 major high-yield crises, which we define as a period when the high-yield spread went up above 6% (a standard deviation above the long-term average of 4%). In 8 out of these 11 high-yield crises, leveraged equities suffered a >20% drawdown. The other three were contained within specific sectors and didn’t affect value stocks.
We created a table of these eight major incidents below. (We should note that there were two additional >20% drawdowns in leveraged equities unrelated to high-yield crises, notably in 1987 and 1990).
Figure 1: High-Yield Crises that Caused >20% Drawdowns in Leveraged Equities
Source: Federal Reserve Bank of St. Louis (FRED), CapitalIQ, and Verdad Research
In the average crisis, high-yield spreads rose by about 4.5 percentage points from trough to peak over a period of 16 months, causing a 35% drawdown in leveraged equities. This is the risk that investors in leveraged equities get paid to take: a stomach-churning drawdown in one out of every six or seven years.
But the recoveries from these drawdowns have been as fast as the drawdowns were painful. The average recovery to the high-water mark prior to the crisis took nine months as leveraged equities rebounded 68% on average in that short period. These crises might mean that investors earn zero on their investment in leveraged equities over a two- or three-year period, but unless they sell at the bottom, the impairments have been short-lived.
Regressing changes in high-yield spreads against the returns of leveraged small value stocks shows a strong statistical relationship: when high-yield spreads increase by 1 percentage point, leveraged small value equities decline by around 4.7 percentage points on average.
Returns on leveraged small value equities thus depend in part upon the condition of the high-yield market at purchase: the narrower the spread, the further leveraged small value equities could fall if a crisis hits. A regression of high-yield spreads vs. leveraged small value equities suggests as a rule of thumb that the expected one-year forward returns of leveraged small value are roughly five times the current high-yield spread (e.g., high-yield spreads today are at 3.7%, which would imply a return of around 18%).
Given what we know about high-yield spreads as a risk factor for investing in leveraged small value equities, would it be advisable for investors to attempt to time this strategy? We tested two simple market timing strategies and compared them to a long-term strategy of buying and holding:
Timing Strategy 1 invests in leveraged small value whenever high-yield spreads are less than one standard deviation above their historical average, and switches entirely to Treasury Bills during high-yield crises when spreads are more than one standard deviation above their historical average. The goal of this strategy is to get out of equities at times of crisis.
Timing Strategy 2 only invests in leveraged small value equities when high-yield spreads are greater than one standard deviation above their historical average; at all other times when the high-yield spread is within one standard deviation, it invests in the market portfolio. The goal of this strategy is to invest in leveraged small value equities only when the expected returns are highest.
You can see the results below.
Figure 2: "Buy and Hold" vs. Various "Timing" Strategies (Apr 1965 – Dec 2017)
Sources: FRED, Ken French Data Library, CRSP, and Verdad Research
Empirical evidence over the past 52 years suggests that it would have been better to stay the course of a leveraged small value strategy rather than attempt to time this equity segment based on changes in the high-yield spread. In order to implement this principle in real life, we believe it is crucial that investors understand their risk exposures. Knowledge dispels fear, so a clear understanding of risk exposures can help investors to capture the premiums offered in equity markets by staying the course when others throw in the towel.
We have a unique approach to active management at Verdad. We don’t promise to make money in good times and in bad times. We don’t promise to shield investors from the volatility of the market. Rather, we seek to make money from volatility by taking smart bets in a segment of the market that has historically provided above-average returns at the cost of a painful drawdown every few years. We believe this strategy provides the best absolute return of any long-only equity strategy, but investors can only make money on the strategy by understanding the risks they are taking and how the strategy performs.
Forewarned is forearmed, and we believe that fully educating our investors about the risks of our strategy is the best way to ensure that when the next crisis inevitability arrives, investors will be prepared to not only hold through the bottom but also add to their positions at the time of maximum pain and maximum gain.
* Although the Federal Reserve’s high-yield spread data only extends back to 1998, we created a synthetic data set that extends further back using the BBB spread.