• Companies issue both debt and equity to finance their operations, and their valuations should be linked to the enterprise value of the firm. However, due to investor segmentation, the capital market imposes little discipline in valuing the two (contingent) claims in a consistent manner.
  • As a result, over the past 45 years, exposure to U.S. investment grade credit spreads had a Sharpe ratio that was roughly half of the Sharpe ratio of U.S. equities.
  • Corporates have responded to this opportunity by increasing leverage. Yet there are natural limits to how far and how fast companies can respond, since excessive leverage lowers corporate flexibility.  Reorganization costs are nontrivial, which limits leverage as well.
  • All this is good news for investors willing to actively trade across the capital structure. At PIMCO we use the capital structure framework in two ways:
    • Micro/Cross-Sectional value: Over the last two decades, a long/short portfolio of bonds screened on the basis of cheapness relative to the equity market and based on this framework performed well. We also use this framework to identify attractive opportunities in sectors (like financials) where companies issue corporate bonds with various degrees of seniority.
    • Macro/Beta timing: Our framework models the aggregate corporate bond market as a single firm, and uses the balance sheet of the entire corporate sector to compare valuations across credit and equity markets. In contrast to equity beta, which is notoriously difficult to time, we find that the credit risk premium tends to be more predictable. We therefore believe this is a promising avenue for top-down beta timing in multi-asset portfolios.

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The Author

Mukundan Devarajan

Quantitative Research Analyst, Asset Allocation Research

Ravi K. Mattu

Global Head of Analytics

Vasant Naik

Head of Asset Allocation Research

Rama S. Nambimadom

Head of Credit Analytics

Mihir P. Worah

CIO Asset Allocation and Real Return

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This paper contains hypothetical analysis. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Stress testing involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events.  These methodologies can include among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments.

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. It is not possible to invest directly in an unmanaged index.

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