Swedroe: Differing Definitions Of Quality

August 05, 2016

Quality In Bonds
As a further test of the quality premium’s robustness, the authors examined whether it existed in corporate bonds. Their corporate bond data set was constructed on the Barclays U.S. Corporate Investment Grade Index and the Barclays U.S. Corporate High Yield Index over the period January 1994 through December 2014. They only included bonds for companies with publicly traded equity due to the availability of accounting information.

In the case of multiple bonds outstanding, they include only one, preferring 1) senior bonds over subordinated ones; 2) bonds in the maturity segment of five to 15 years; 3) younger bonds; and 4) larger bonds. The final sample consists of 414 investment-grade bonds and 474 high-yield bonds.

The authors based their corporate bond analysis on returns in excess of duration-matched Treasuries, allowing them to focus on the default premium component of corporate bond returns, ignoring the term premium (which can be gained by investing in government bonds). Due to the lower liquidity of corporate bonds compared to equities, they chose a 12-month holding period, versus the one-month period used for stocks. Following is a summary of their findings:

  • The top portfolios of investment-grade bonds based on “industry” and “academic” quality definitions outperform the market in terms of excess return as well as on a risk-adjusted basis (with Sharpe ratios of 0.18 and 0.17 compared with 0.11 for the market), showing evidence for a quality premium.
  • The results for high-yield bonds show strong evidence that an investment strategy based on quality can also be profitably applied in corporate bond markets. Further, the superiority of the “academic” definition proves robust once again, with a top-minus-bottom premium of 3.1% (and a t-statistic of 2.51) compared with 0.6% (and a t-statistic of 0.4) for the “industry” definition.
  • A closer examination of the risk and return profiles for the top- and bottom-quality portfolios hints that investing in high-quality bonds effectively lowers the risk of default and earns a return premium.

The authors offered this important observation: “Perhaps the most striking take-away from this study is that there are large discrepancies between the stock quality measures used in academic studies and in the industry. Not only in terms of definitions that are used, but also in terms of the predictive value they have for future stock returns.”

This seems to be a case where the mutual fund industry, in aggregate, is ignoring the academic evidence. Given the efficiency of the market, it seems unlikely that this “ignorance” will continue, at least to the degree observed in this study. In the meantime, investors are best served by investing in funds that follow the evidence found in the academic literature.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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