When It Rains, It Pours: Distance to Default in Systematic Equity Investing
Equity investors should closely follow fixed income markets. Investing in equity of companies with a lower degree of credit risk may pay off to a greater extent during turbulent market periods, whereas investors could benefit the most from companies closer to default via their larger equity risk premium during rallies or rebounds from crises.
The insights in this paper can be applied to either decrease the risk in an equity portfolio or to gear the portfolio to a higher upside in a risk-on phase.
We attempt to evaluate the effectiveness of Merton’s Distance to Default (DD) measure in systematic equity investing, using a developed markets large and mid-cap universe of stocks as our basis. To do so, we analyze the characteristics of a set of sector-neutral DD-sorted quintile portfolios over a timeframe spanning from May 2006 to June 2021. A higher Distance to Default implies a lower credit risk.
Based upon our results, we can observe that:
- Our DD measure appeared to have a procyclical behavior on aggregate. This can be reflected by DD decreasing during periods of market turmoil whilst increasing during rallies.
- Safer portfolios – according to their implied credit risk – exhibited a lower drawdown, volatility, and beta relative to their riskier counterparts, as well as their benchmark, offering a greater degree of protection during market downturns relative to riskier ones.
- Riskier portfolios tended to outperform during most market rallies.
Given these observations, DD could be used as a means for investors with convictions regarding credit risk to gain exposure to equities that would perform well based on their view of the market.
Please note: Below we publish an extended version as well as a short version of the paper.