A Quant-Driven Approach to Investment Grade Bonds
December 01, 2020
Watch Time 9:12 MIN
Bill Sokol, Director of ETF Product Management, discuss our partnership with Moody’s Analytics, and how its data is being used to seek attractively valued corporate bonds while controlling for credit risk.
Jenna Dagenhart: Joining us now to talk about the launch of two new fixed income funds is Bill Sokol. He's Director of ETF Product Management at VanEck. Bill, you're collaborating with Moody's Analytics on this. So, tell us how you're using their data to find the right bonds for these funds.
Bill Sokol: Thanks, Jenna. We're really excited to partner with Moody's Analytics on these two new funds, the VanEck Vectors® Moody's Analytics IG Corporate Bond ETF (Ticker: MIG) and the VanEck Vectors® Moody's Analytics BBB Corporate Bond ETF (Ticker: MBBB). We think that a quantitative approach makes a lot of sense in the investment grade bond market when you're trying to identify the most attractively valued bonds, because it allows you to be more forward looking and take into account what the market is telling you. That's in contrast to a more fundamental approach through financial statement analysis, or by relying on credit ratings alone, which tend to lag the market, and probably won't provide you with the right signals that are frequent enough in order to identify these value opportunities when they arise. Moody's Analytics is the industry leader in terms of credit risk modeling. Their model is backed by an extensive data set of global bond default and recovery data over several decades.
Bill Sokol: It's also supported by a team of over 30 researchers. And that's why hundreds of the world's largest institutions rely on Moody's Analytics for their credit risk management decisions. Both funds seek to track indexes that are powered by data from Moody's Analytics, and what they do is they select the most attractively valued bonds from the broad investment grade or the broad BBB corporate bond space. They select bonds that have the highest credit spread relative to their fair value, as determined by Moody's Analytics. In other words, they select bonds with the highest excess spread, which means that you're earning more than the fair value you need to compensate for the embedded credit risk of these bonds. Ultimately by choosing bonds that have the highest excess spread, you're buying something that's cheap relative to the risk, and that represents upside potential as the market spread converges towards fair value.
Bill Sokol: An additional screen that both strategies incorporate is excluding bonds that have the highest probability of being downgraded to high yield. Default risk is always going to be the primary driver of credit risk with any bond. But within investment grade bonds, downgrade risk is also impactful, and that can be particularly true within BBB corporate bonds. A lot of investment grade bonds that the market believes will be downgraded to high yield get sold off in the months prior to downgrade. So, bonds with high probabilities of downgrade are excluded, so that we can potentially avoid the negative price impact associated with these downgrades. Ultimately, what you have is a portfolio that we believe provides attractive compensation relative to the level of credit risk that you're taking.
Jenna Dagenhart: So trying to steer clear of those fallen angels.
Bill Sokol: That's right.
Jenna Dagenhart: And both funds focus on investment grade corporates. One is broad, and one is strictly the crowded BBB Space. Why does selection matter here?
Bill Sokol: So again, we try to focus on the bonds that have the most attractive valuations. And when you look at the broad market, there's a lot of dispersion in terms of where the market is pricing risks, not only in terms of the market spreads that are achievable in the market, but also the embedded credit risk in the market. And actually, you can look at different issuers that have the same credit rating bonds with the same duration, same amount of liquidity. And you see that the pricing can be all over the place. So, it's important to accurately assess the risk in the market, and to do so, you need an accurate credit risk model. And that's what we have achieved by partnering with Moody's Analytics. What we have found is that historically attractively valued bonds have produced outperformance.
Bill Sokol: When you segment the broad market into bonds that have high excess spread versus low excess spread, we actually have found in the investment grade space that these high value bonds have outperformed low value bonds by about 170 basis points per year, on average, over the past decade and by about 250 basis points on average within BBB space over the past decade. That's clearly very compelling from an absolute return perspective, but more than that, there's this inherent quality screen built in. So, you're not having to take on an excessive credit risks to maintain an attractive yield and to benefit from that outperformance.
Jenna Dagenhart: Now finally Bill, how should investors be thinking about incorporating these funds into our portfolio?
Bill Sokol: We all know that we're in this environment right now, very low yields and low spreads, and this low rate environment is going to be with us for the foreseeable future. A lot of the investment grade investors may be tempted to take on a lot more risk in their portfolios in order to maintain an adequate level of income, and we think that there's certainly a lot of value in asset classes like high yield, emerging markets debt, even equity income within an income portfolio. But we also think that investment grade corporate bonds really fit into a core bond portfolio, which is really meant to provide income, but also safety and act as a ballast against the riskier exposures within your portfolio. So, we think incorporating value and quality into an investment grade strategy makes a lot of sense in order to maintain an adequate level of income and to do so without taking on excessive risk.
Bill Sokol: So we think that the broad investment grade strategy can be a great way to get your broad corporate bond exposure within a Core Bond Portfolio. And to benefit from the spread pickup you get with a corporate bond exposure. BBBs, of course, are on the riskier end of the investment grade universe, and we think that these value and quality screens can have particular value within this universe. So, we think that for investors who want a little bit more yield and are willing to take on a little bit more risk, the BBB Strategy can fit very neatly into a well-diversified value oriented corporate bond portfolio. I also think that the BBB strategy could be a very nice compliment to a fallen angel high yield strategy for investors who are looking for higher levels of income. Fallen angel high yield strategy takes advantage of that lag in credit ratings and the structural inefficiency that's caused by the forced selling of investment grade bonds that are expected to be downgraded to high yield and picks up these bonds at deep discounts on average.
Bill Sokol: So again, it's another value-oriented credit strategy. As I mentioned, our BBB strategy seeks to avoid these potential fallen angels by using the data for Moody's Analytics to try to avoid bonds that have a high probability of being downgraded to high yield. So, you'd hope to not have a lot of overlap in these two strategies, hope to avoid the negative price impacts associated with downgrades in your investment grade strategy while benefiting from that upside potential within a fallen angel high yield portfolio. So overall, we think that these strategies provide a very smart approach to the investment grade corporate bond market. They allow investors to maintain this attractive level of income that you can get from corporate bond exposures that provide that spread over risk-free Treasuries and also your total return potential, but without having to take on excessive risk within a core bond portfolio.
Jenna Dagenhart: Well, Bill really nice to have you. Thanks for joining us.
Bill Sokol: Thanks for having me.
Jenna Dagenhart: And thank you for watching. That was VanEck Director of ETF Product Management, Bill Sokol, and I'm Jenna Dagenhart with Asset TV. To receive regular updates from VanEck’s experts, please visit vaneck.com/subscribe.
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