Investing with Style in Liquid Private Debt (2022)
Thomas Mählmann, Galina Sukonnik
Financial Analysts Journal 78(3), URL
This week’s AGNOSTIC Paper is yet another out-of-sample test of the Momentum and Value factor. The authors apply the factors within the relatively new asset class of private debt. More specifically, for “[…] loans to non-investment grade issuers, commonly known as leveraged loans.” This is obviously not my main area of expertise, but I learned from the paper that there is quite some trading of such loans in private secondary markets. Implementing a factor strategy for leveraged loans is obviously more complicated than for equities, but this is exactly what makes this study so interesting.
Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.
Data and Methodology
The authors focus on loans to highly leveraged borrowers, i.e. the credit risk/high yield segment of the syndicated loan market. Again, I am not an expert in this field but many of such loans represent the debt capital for private equity transactions. Just to give you a feeling about what kind of debt we are talking. According to the authors, the annual trading volume of such loans in secondary markets grew from $145B in 2003 to $772B in 2020. All trading happens privately and therefore it is quite difficult to analyze this market.
The authors collect data from various sources and apply a bunch of conservative filters to get a realistic opportunity set for leveraged loan investors at each point in time. Overall, this yields a sample of 1,953 loans from 1,161 unique borrowers within the period between July 2010 to December 2015. The authors don’t mention this explicitly, but I am pretty sure that they just focus on the US market.
Due to the special nature of the leveraged loan market, coming up with definitions for Value and Momentum is also not as simple as for equities. With respect to Momentum, the authors explain that the factor “almost naturally emerges” within leveraged loans because of gradual information diffusion in private markets. They use the one-month return of the mid-quote as signal for short-term momentum. For Value, they use the ratio of a loan’s spread to its volatility. By this definition, a “value loan” offers more spread (return) per unit of risk. Finally, they also look at the combined ranking as it is well-known that Value and Momentum perform even better in combination.
Important Results and Takeaways
Private debt improves multi-asset portfolios
Unrelated from factors, the authors first show that leveraged loans are generally worth considering in a portfolio context. Specifically, they show that leveraged loans provide diversification benefits to a “traditional” multi-asset portfolio consisting of public and private equity, real estate, and bonds.
As the figure shows, adding leveraged loans clearly extends the efficient frontier. The diversification benefits are especially relevant for investors who aim for expected returns in the range of 4-5%. By diversifying into leveraged loans, they can achieve such targets at considerably lower volatility. Same return at lower risk means higher risk-adjusted performance and this is obviously what we all like.
Value and Momentum are profitable within private debt
Now to the leveraged-loans-factor-strategies which are of course the heart of the paper. The authors use their Value and Momentum signals to sort leveraged loans into equal-weighted tercile-portfolios in each month of their sample. The following chart summarizes the results of this hypothetical strategy for the entire sample period between July 2010 to December 2015.
I think the chart mostly speaks for itself. The Value and Momentum portfolios beat the Index, an equal-weighted portfolio of all leveraged loans, over time. Similarly, leveraged loans with Low Value and Momentum scores underperform the index which indicates that the two factors really explain the cross-section of returns in this asset class.
It is of course almost impossible to trade leveraged loans monthly and even more difficult to short them. To account for these issues and make the results more practical, the authors also present their portfolios as long-only strategy with a more realistic holding period of 12 months for each loan. The following table again summarizes the performance.
The results are a bit weaker but the overall pattern remains the same. Even with the frictions of private debt markets, Value and Momentum signals help to generate outperformance. Leveraged loans with high (low) Value and Momentum scores still outperform (underperform). This indicates that the trading strategies survive real-world implementation issues and actually seem to be profitable for investors. Needless to say, those practical results are even stronger evidence for Value and Momentum in this asset class.
Conclusions and Further Ideas
The authors replicate the Value and Momentum factor in the quite new and relatively special asset class of private debt / leveraged loans. They find significant risk-adjusted returns and even show that the outperformance survives real-world implementation issues. By and large, this is further evidence that Value and Momentum most likely come from real economic mechanisms instead of data mining.
From a broader perspective, the paper is part of a growing literature on the application of the major factors in other asset classes than equities. Several researchers and practitioners already found and implemented factor strategies within the corporate segment of the fixed income market. Expanding that work into private markets is just the next logical step and I am quite sure that it is only a matter of time until we see the first private market factor fund. If it doesn’t already exists somewhere…
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