Defensive investing
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Defensive investing

Defensive investing requires more than adding non-cyclical and dividend stocks to portfolios. Explore how we build defensiveness into portfolios by evaluating equities through the lens of a credit investor.

Overview

Many investors are looking to defensive allocations in to help manage persistently low global bond yields and heightened equity volatility. We see potential opportunities to generate defensive returns by analyzing equities from a debt investor’s perspective.

Key Points

01

A matter of life and debt

Elevated leverage levels make understanding a company’s debt profile critical to defensive equity security selection.

02

Uncovering cross-asset insights

Defensive investment strategies may benefit from consistently evaluating information from both the equity and debt markets.

03

Getting defensive

Defensive alpha, which is driven by structural and behavioral market forces, may help generate a defensive and diversifying return stream in a portfolio.

Elevated corporate debt levels are a secular trend

The US economy has been in an extended period of low interest rates for over a decade. At the same time, a global search for yield has lead to strong investor demand for corporate bonds. The result has been increasing levels of corporate leverage, as companies look to benefit from low rates to fund their growth.1

This trend can be seen by looking at leverage ratios in the US Investment Grade debt universe. As you can see in the chart over the past 15 years, there has been a significant increase in the leverage ratios of companies. While markets have typically de-levered following economic downturns, we believe heightened corporate debt loads are a secular trend. The factors contributing to more corporate indebtedness continue to strengthen. Given low rates for companies to issue debt and the continued demand for yield globally, corporate leverage levels are likely to remain elevated relative to historical averages.

Our expectation is that increased leverage will act as a magnifying force to make a company’s debt profile an incredibly important source of information for asset returns in future economic slowdowns or market shocks.

A world of rising leverage may require greater equity investor attention

Percentage of U.S. investment grade debt in each gross leverage bucket

Chart that shows the US Investment Grade debt universe over the past 15 years.

Source: BlackRock, Morgan Stanley, as of 31 December 2020. 

Companies are exposed to debt and equity risk... But do investors pay consistent attention to both?

One interesting output of our research has been a realization that equity investors do not consistently value debt information in their analysis.

For companies that are reliant on both the equity and the debt markets for funding, it is critical to pay attention to both. Moves in one asset class can have a dramatic impact on the other. Surprisingly, we have found that equity investors do not always pay sufficient attention to credit markets. During market crises, we saw discussions around credit quality to be common for equity investors, but in more normal times, details of the credit market are often an afterthought. We find this to be a behavioral mistake.

One reason for this inconsistent attention could be the segmentation that has existed within the asset manager community between equity and bond funds. Even though bonds and equities are issued by the same companies, the investor bases looking at these securities have often been separated into distinct groups by asset class.

Most asset management companies have separate equity groups and credit groups. Institutional clients often have separate teams that conduct due diligence on fixed income and equity products. Even sell-side research is published by separate teams based on asset class. As a result, equity investors tend to inconsistently evaluate the debt-related information of the companies they cover.

The opportunity for cross-asset class insights

Why the disconnect? While there are several possible reasons, we believe this divergence in focus across the two asset classes is largely driven by the different outcomes that each investor type seeks to achieve.

Payoffs can drive focus, but market direction can shift the importance of information

Payoffs by security type and information importance based on market direction

Chart of the equity and debt security payoffs.

Source: BlackRock. Based on the views and opinions of the Systematic Fixed Income group, as of April 2021. Charts are for illustrative purposes only and are not meant to depict past or future results.   

Equities have a more symmetric payoff profile with meaningful upside potential. Thus, most equity professionals are paid to focus on the upside. Since equities represent a growth option on a firm’s business operations, equity investors focus more on income statements, earnings growth, product rollouts, and long-term growth prospects when analyzing a company.

Credit investors, on the other hand, care less about growth and more about how that growth will be funded. Notably, the structure of debt securities is such that investors face the prospect of little upside potential and significantly more downside risk. Thus, debt investors are incentivized to focus on the downside, leading to more attention paid to balance sheets, default probabilities, and cash flows.

These behavioral silos act like invisible boundaries between the markets that inhibit the efficient and consistent transfer of information. As a result, we believe that equity and credit analysts tend to focus more heavily on information specific to their respective market. Due to this segmentation, we find that equity market information gets priced into the equity markets quickly, and credit information also gets priced into the credit markets quickly—but both sets of information are not quickly priced into a single asset class efficiently. 

In our experience, the cross-market mispricing of information can be more persistent due to the natural segmentation of market participants.

Why and when debt matters the most

Credit-based insights matter because debt levels increase a company’s chances of default.  However, during recessions or in times of market stress this long-term concern can become a more immediate and pressing issue.

Companies that had the ability to access debt and equity capital markets to fund operations in strong economic times may find that their funding spigot gets turned off during recessionary periods. This can result in increased equity volatility as high debt loads lead investors to question future profitability or even debt sustainability. In such a case, we find that for equity valuations, equity-related metrics take a back seat to credit-related metrics.

Looking back at the previous figure, we find that market direction can play a major role in shifting the focus of market participants and reprice equity assets once overlooked credit-related information is accounted for.

An alternative approach to defensive investing

Consider an alternative approach to defensive investing that taps into market dispersion (not just market direction) as a source of potential return. Dispersion is the difference in returns across a universe of companies. High dispersion implies a wide difference between winners and losers, while low dispersion implies a more narrow difference. One effective way to take advantage of dispersion is through market neutral long/short strategies that go long companies who may become winners, while shorting companies that may become losers.

Our approach to defensive equity investing seeks to generate returns in a long/short framework based on the dispersion of companies that are highly levered. We call this source of return defensive alpha. The persistence and effectiveness of defensive alpha is rooted in market structure and the behavioral disconnect between equity and debt investors.

Forces underpin defensive alpha’s potential to be a source of return

Dispersion may rise when markets fall
As the figure below highlights, equity dispersion (yellow line) has historically been highest when markets are most volatile of falling (green area).
Leverage may increase market dispersion
More leverage on the balance sheet (orange line) may amplify a company’s stock return—both up and down- creating greater winners and losers.
Equity returns may be more dependent on debt metrics during drawdowns
This higher level of dispersion among levered companies can be heightened when markets are volatile, as demonstrated by the spikes during past market shocks.

Dispersion levels are elevated during volatility, especially among levered companies

Market volatility and return dispersion of S&P 500 vs. highly levered companies

Chart of the equity and debt security payoffs.

Source: BlackRock. Based on the views and opinions of the Systematic Fixed Income group, as of April 2021. Charts are for illustrative purposes only and are not meant to depict past or future results.   

Why the higher levels of dispersion? This is because equity-related metrics dominate valuations in normal times. During down markets, credit-related metrics dominate, increasing dispersion of levered companies as the information is realized. Our research shows the more stressed the market, the more important credit-metrics become.

The tendency for equity investors to reprice securities based on debt metrics during stressed markets acts as an in important structural return driver for defensive alpha. Its opportunity set to go long winners and go short losers grows when dispersion widens. Thus, in normal times defensive alpha can be an incremental source of return, but may spring into action when markets are declining—the very time you need defensiveness most.

Bottom line

As systematic investors, we strive to deliver specific outcomes to investors by targeting explicit return sources. By separating sources of returns into directional (beta and factors) and idiosyncratic (alpha) components, we can engineer highly customizable return streams to seek specific risk, return, and diversification* properties.

Defensive alpha, and its potential to take advantage of dispersion to produce positive idiosyncratic returns when equity markets sell-off, is just one of the differentiated return streams we seek to target in our strategies.

In an environment of low fixed income yields and heighted equity market volatility, we believe defensive alpha offers an alternative source of diversification and return that can help investors build more resilient portfolios.

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Learn how a credit investor’s defensive approach to equity investing can help build more resilient portfolios.
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Tom Parker, CFA
CIO of Systematic Fixed Income
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Chad Meuse
Head of Equity and Capital Structure
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Jeffrey Rosenberg, CFA
Sr. Portfolio Manager
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