Discount, risks and risk premium
The objective of active management is to generate additional performance compared to the ultimate risk-free benchmark: the money market investment. The price of a risky asset, whose cash flows (dividends, coupons) are uncertain, must include a discount to its certain equivalent. This discount, which determines the risk premium, is not incidental. It remunerates the risks incurred by investors. Capturing a risk premium therefore requires judgement on the adequacy of this discount to the identifiable risks.
The existence of an ex-ante premium is inseparable from investors' aversion to loss and risk. The credit market is characterised by the potential default of the issuer. Holding a risky bond is equivalent to selling a put on the value of the borrowing company's assets. Default risk creates this asymmetry that justifies the premium linked to the aversion to the creditors’ loss. This asymmetry can be found in equity markets. Protection against a stock market crash is notoriously more expensive than an index upside option.
While asymmetry reflects loss aversion, investors' risk aversion leads to a second type of premium. The risks of illiquidity of an asset, downgrading of an issuer's rating or systemic financial risk are present in all markets to varying degrees. Capturing a risk premium means identifying excess valuations.
Capturing the Equity Market Volatility Risk Premium
The volatility risk premium is closely related to a known behavioural bias, the loss aversion bias: individuals on average feel twice as much pain from a €100 loss as they feel joy from an equivalent gain. In the options market, this bias creates an imbalance, resulting in a demand for protection against market drawdowns that significantly exceeds supply. Consequently, protection sellers find themselves in a position of strength and demand a premium to assume the risk of drawdown. As a result, there is a volatility risk premium in equity markets that can be captured to generate alpha.
This generally involves selling volatility, usually by selling options on equity indices. Two main implementations are possible:
* cover all risks except for volatility to achieve a pure carry strategy
* cover all risks except for volatility and directional risk to achieve a strategy that benefits from both volatility normalisation and market rebound
To optimise the risk-return profile of a volatility selling strategy, we are convinced that it is necessary to dynamically allocate between these strategies based on market conditions. In calm market conditions, it is preferable to take advantage of the carry by reducing directional risk. Conversely, after a market shock, there is an opportunity to benefit from a potential rebound by increasing directional exposure.
Capturing credit spreads
In the corporate bond space, humans’ aversion to risk is materialised by the so-called “credit spread”: the excess remuneration for taking on credit risk vs “risk-free” debt. To capture this premium with a fair degree of stability, we focus on the following.
First, credit research to gain a deep, forward-looking understanding of the fundamentals and the dynamics of the company’s business and its capacity to deliver recurring cashflows.
Second, because, unlike stocks, bonds are an asymmetric asset class, issuer diversification is required to mitigate unwanted idiosyncratic shocks. Probably, a 3% maximum portfolio weight per issuer is a good yardstick is most situations.
Third, one needs to optimize relative value amongst the many candidates for inclusion in the portfolio. Under the classic quantitative approach of the Merton model, a corporate bond is equated to a short put option position on the assets of the firm and hence the level of its credit spread is positively correlated with its equity volatility. Obviously real life is more complex, but this model can be used to identify opportunities or inefficiencies. For example, a dividend cut may increase stock volatility and credit spread, but on the other hand such an event can be seen as a boon for bondholders. Alternatively, relative value can be assessed more qualitatively by comparing the credit spread vs the perception of credit fundamentals.
Finally, keeping a decent cash level makes sense to capture opportunities in volatile market conditions. Keeping cash on an ongoing basis creates a drag but this is more than recouped when markets seize up and cheap investment opportunities arise. This strategy is akin to holding an out-of-the-money option on credit spread volatility.
