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Efficient Credit Hedging With the Quality-Junk Factor
By: Michael Green, CFA, Portfolio Manager & Chief Strategist David Berns, PhD, CIO & Cofounder, Simplify Asset Management
The credit crisis that emerged in the mortgage market in 2007-2008 brought credit hedging into the spotlight, revealing both its potential and its pitfalls. While instruments like Credit Default Swaps (CDS) once promised asymmetric returns, regulatory shifts and policy changes have diminished their effectiveness. With high costs and underwhelming results, investors are left questioning whether credit risk can still be hedged efficiently. This blog explores how a long-short approach to the quality-junk (Q-J) factor could offer a more effective solution in today's challenging credit environment.
Introduction
The extraordinary credit crisis that emerged in the mortgage market in 2007-2008 introduced the investment world to the concept of credit hedging and the potential for asymmetric returns in financial products like Credit Default Swaps (CDS). Unfortunately, enthusiasm for these trades, regulatory changes, and policy responses changed the available payoff profiles in credit hedges. As a result, investors have been relentlessly disappointed with credit hedging techniques, even as the return potential in credit has declined with tight credit spreads and low risk- free yields.The high cost and disappointing performance of credit hedging leave investors with a quandary – how, if at all, can credit risk be hedged efficiently? This blog shows how a long-short exposure to the quality-junk factor (Q-J) can potentially function as an efficient credit hedge within a costly hedging space.
Theory Behind Credit Hedging with the Quality-Junk Factor
In 1974, Robert Merton introduced the “Merton Model” of credit and equity as competing claims on underlying asset value. In this model, equity can be thought of as a call option on the value of total firm assets above the notional (face value) level of debt, as depicted in Figure 1.
Figure 1: Merton's Model of Equity as a Call Option
As many academics and practitioners have noted, this relationship introduces the potential to model credit exposures and credit hedges as options as well. For example, the creation of Credit Default Swaps (CDS), made famous in Michael Lewis' book, The Big Short, relied on these insights to create the equivalent of a call option on credit default risk.
The Merton model naturally leads to an alternative to using CDS to obtain credit hedging properties – an equity long/short expression that pairs a long in high quality, low leverage equities with a short in low quality, high leverage equities. The quality equities are essentially deep-in-the-money calls (on asset value), while the junk equities are at-the-money calls, creating an asymmetric response from the long/short portfolio when a risk-off event occurs and asset values drop below debt face values for the junk names.
Let's now take a look at this empirically.
The Quality-Junk Factor in Practice
We create our quality basket by screening for the highest decile of names by margins, profit stability, and balance sheet strength from the 1000 most liquid stocks and enforcing equal-weight sector exposures. We then create a junk basket from the same 1000 names, again with sector limits, screening for the highest decile of sensitivity to an increase in debt refinancing costs. These legs don't mirror each other from a characteristics perspective on purpose; we do not want to overweight a single factor causing excessive volatility in the hedge. Our Q-J portfolio is then 100% long Q and 70% short J, to stay near beta-neutral. This configuration is also relatively sector-neutral, helping avoid unintended basis risk through extreme allocations to any given sector.
Figure 2: Hypothetical Q-J vs High Yield
From the lens of the above screening criteria, the prediction that Q-J should act as a credit hedge seems intact: the long Q position has low sensitivity to financing costs (credit spreads) while the short J has a high sensitivity to widening credit spreads. In Figure 2, we show hypothetical performance for this definition of Q-J compared to high yield markets using a backtest. As expected, we see strong outperformance during risk-off periods, precisely acting like a credit hedge. In addition, we also see a very positive carry outside of the risk-off events, an incredibly beneficial feature for a credit hedge in low-yield environments.
Figure 3 takes another look at the credit hedging properties of Q-J. Again, we see that the correlation to high yield is consistently negative in the worst- performing months for high yield credit, even while the absolute return from the hedge is positive – again, a critical consideration in an environment of low absolute returns.
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Figure 3: Q-J Conditional Correlations to High Yield
Conclusion
In an environment characterized by low absolute yields and high levels of corporate credit risk, efficient credit hedging becomes much more critical in portfolio construction. Fortunately, we believe this is possible. A thoughtfully constructed overlay of quality vs. junk equity in a long/short implementation potentially offers a combination of positive carry with negative correlation to credit, creating the potential for improved returns at lower risk.
Figures 2 and 3 Source: Calculations by Simplify Asset Management. The results are hypothetical and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Hypothetical strategies and indices presented are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
Disclosure: Simplify Asset Management Inc. is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Simplify Asset Management Inc. and its representatives are properly licensed or exempt from licensure. SEC registration does not constitute an endorsement of the firm by the Commission, nor does it indicate that the advisor has attained a particular level of skill or ability. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy. This website and information are not intended to provide investment, tax, or legal advice.
This website is solely for informational purposes and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. These materials are made available on an “as is” basis, without representation or warranty. The information contained in these materials has been obtained from sources that Simplify Asset Management Inc. believes to be reliable, but accuracy and completeness are not guaranteed. This information is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Neither the author nor Simplify Asset Management Inc. undertakes to advise you of any changes in the views expressed herein.
Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.
Unless otherwise noted, any performance returns presented in these materials reflect hypothetical performance. Hypothetical strategies and indices presented are unmanaged, do not reflect any fees, expenses, transaction costs, commissions or taxes, and one cannot invest directly in any of these. The results presented should not be viewed as indicative of the adviser' skill and do not reflect the performance results that were achieved by any particular client. During this period, the adviser was not providing advice using this model and clients' results may have been materially different. Hypothetical model results have many inherent limitations, some of which, but not all, are described herein. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading.
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