Quant Strategy Shows Investors Hate Leverage Like It's 2009

(Bloomberg) -- The expansive stock rally over the past year masks an ugly truth: investors are worried about corporate debt as tighter monetary policies loom.

A concentrated portfolio that bets on U.S. companies with the most leverage is on track to decline for a fifth consecutive quarter, the longest losing streak since 2009, according to a market-neutral Bloomberg index. European stocks with the weakest balance sheets show a similar story, with year-to-date losses piling up thanks to the February rout despite a reprieve last week.

“If 10-, 15-year yields are going up, or even 30-year yields, high leverage companies would have to pay more in interest expenses and it would be harder for them to refinance,” said Vitali Kalesnik, chief equity analyst at Research Affiliates LLC.

You’d be forgiven if you missed the bubbling undercurrent of interest-rate risk in equities on this scale. But dissect the market like the quants do -- buying companies with the most leverage and shorting the ones with the least -- and the concern becomes clear. You’re left with what quants call a factor portfolio, which hedges out broader market movements to paint a clear picture on the performance of indebted companies.

That means the portfolio -- which tracks 1,840 stocks in total, about half of which are shorted -- can’t be saved by the lifting force of cash-rich mega-cap stocks. Instead, the leverage factor has been dragged down by fears over rising refinancing costs.

“In the last 12 months it has been unusually negative, a three or four standard deviation event,” said Melissa Brown, managing director of applied research at Axioma Inc., a provider of tools for risk management and portfolio construction. “The market tends to react more to changes in direction than to levels, and I imagine that’s the major reason we’re seeing this negative return.”

February was a particularly telling month as U.S. 10-year yields touched their highest level in four years. That, in turn, steepened losses for the leverage factor, which tumbled the most since 2016.

That contrasts other equity factors -- like momentum or growth -- which have stayed afloat for the majority of the year. Out of the 10 factors tracked by Bloomberg, leverage fell the most last month.

So far in March, the factor has stayed mostly flat as 10-year yields trade in a relatively stable range.

Most quants don’t track market-neutral leverage as the standalone investment strategy, rather they may incorporate it as a signal in a larger, multi-factor fund. Credit investors, meanwhile, are sanguine as low-rated debt obligations outperform.

And betting on debt hasn’t been a loser outright in every equity-market corner. A long-only Goldman Sachs index that tracks S&P 500 companies with weak balance sheets -- combining leverage and profitability metrics -- has returned 12 percent over the past year. Still, that compares with a 24 percent advance for strong balance-sheet stocks, underscoring investor wariness toward leverage.

Another reason for the portfolio’s underperformance: a lack of help from the market’s highest fliers. In taking into account gearing metrics relative to total assets and book value, Facebook Inc. and Google parent Alphabet Inc. are among those with the healthiest balance sheets. That means the mega-cap tech stocks get a short position in the portfolio -- a death sentence given the top-heavy trading of the past year.

“If some of those mega-caps end up with huge cash flows and are not leveraged, they’d be on the short side of the trade,” Kalesnik said. “It’s an additional story to why these stocks are not doing well.”

To contact the reporter on this story: Dani Burger in London at dburger7@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Sid Verma, Cecile Gutscher

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