challenging trends and opportunities in corporate bonds

Challenging trends and opportunities in corporate bonds

6Stricter rules,

new solutions

12A smarter way to

harvest factor premiums

4The liquidity pitfall

of passive investing

14ESG integration,

in particular for

corporate bonds

1138_0814_E_Credit_Brochure.indd 1 11-08-14 13:28

The Robeco approach for credits 2

Challenging trends and opportunities in corporate bonds 3

The liquidity pitfall of passive investing 4

Stricter rules, new solutions 6

Flexible strategies to benefit from relative value trade-offs 8

More diversification with emerging economies 10

A smarter way to harvest factor premiums 12

ESG integration, in particular for corporate bonds 14

Contents

Further information

E [email protected]

W www.robeco.com/credits

2 | Challenging trends and opportunities in corporate bonds

The Robeco approach for credits

The team follows its own research, not public opinion or the general

consensus. “We always aim to act contrarily in our portfolios,” says

Sander Bus, head of the credit team.

Macro approach for beta positioningGlobal trends are an important element in the investment approach.

These are analyzed every quarter, as external specialists such as brokers

and strategists discuss specific market themes together with our analysts

and portfolio managers in order to assess the risks and opportunities in

the credit market. This top-down macro approach forms the input for

the desired beta positioning of the portfolios. Victor Verberk, co-head of

the credit team: “Understanding the global macro economic environment

is essential to understanding our investment category.”

Sector focus for knowledge advantageThe Robeco credit team consists of 27 portfolio managers, credit

analysts, researchers and traders. The team invests globally and applies

an integrated approach for investment grade, high yield and emerging

credits strategies. This approach is unique. Analysts have a sector

responsibility irrespective of grade or country of origin. After all, sector

developments are global and therefore should be monitored and analyzed

from a global perspective. This approach gives the analysts

a knowledge advantage and gives the team the possibility to capitalize

on the inefficiencies that occur as a result of existing market

segmentations. The credit analysts in the team are all very experienced

in their sector. They are offered the possibility to advance their careers

within their disciplines and to rise above their international peers with

their expertise and seniority.

Sustainability research, integral part of issuer selectionEach analysis is carried out according to a predefined framework. Issuers

are analyzed based on five components, i.e. company strategy, company

position, financial profile, company structure and sustainability criteria.

With regard to sustainability, the analyst analyzes the downside risk

resulting from poor scores on Environmental, Social and Governance

factors. The sustainability analysis is thus an integrated part of our credit

research.

The Robeco credit team manages approximately EUR 21 billion in

various funds and mandates as of the end of April 2014. Assets under

management have increased by approximately 25% a year since 2008.

Robeco’s credit team has an investment style that focuses on thorough research, on which every investment

is based. We believe that the management of a corporate bond portfolio is not about selecting a few of the

best bonds, it is about avoiding the losers in a well-diversified portfolio. This generates alpha.


Challenging trends and opportunities in corporate bonds

Corporate bond markets are in a constant state of flux and continue to

present new challenges to us as asset managers. In addition to the usual

market cycles for investment categories, the bond market is also subject

to structural changes. Not only asset managers and their clients are being

confronted with this, it is also relevant for institutional investors with their

obligations to pensioners and policy holders.

In this magazine we identify a number of market trends, which we believe

are relevant for our clients. We will specifically discuss the challenges that

these trends pose, and more importantly, how we think our clients can

capitalize on these trends.

Changing market conditions can limit the effectiveness of passive investingStricter risk regulations for liquidity providers (banks and brokers) have

structurally changed market conditions. We argue why active managers

are better equipped to capitalize on market liquidity than passive fund

managers.

Stricter rules, new solutionsWe increasingly see that supervisory bodies are tightening the rules on

the financial markets. Examples are Basel III for banks and Solvency II for

insurance companies. As a result, all market players are being confronted

with new questions, but equally important, certainly also with interesting

new investment opportunities.

Flexible strategies benefit from relative value trade-offsFlexible integrated credit strategies are emerging. These strategies can

benefit from making relative value trade-offs to switch between credit

segments. Traditionally, institutional investors tend to select specific

managers for each segment, which can be a disadvantage in today’s

markets. We explain the rationale and the drivers behind the benefits of

flexible integrated strategies.

More diversification with emerging economiesInvestors’ horizons will expand further in the coming years. On the

one hand, information analysis will become more complex due to the

convergence of developed and emerging economies; on the other hand,

this development offers new diversification possibilities for investors.

We believe that an increasing strategic portfolio allocation to ‘new

economies’ will be an important theme in the coming years. We will

discuss our expectations regarding the growing importance of emerging

credits.

Factor investing within creditsWithin Robeco, research has been the basis for every investment since we

first began in 1929. Quantitative research based on market anomalies has

led to the successful introduction of a new type of investment products

based on factor investing. Our ‘conservative’ strategies are based on what

is known as the ‘low-risk’ anomaly. This approach is already known from

equity investments; however, our research has shown that this anomaly

also exists in credits.

More sustainability information results in better investment decisionsAnother important issue for companies and investors is how to deal with

sustainability. Increasingly companies in which we invest are focusing on

sustainability and reporting on this. Investors who are able to interpret

this information correctly and translate this into risks and opportunities

have an information advantage. In this publication, we discuss how to

incorporate sustainable investing and how Robeco integrates this in the

investment process, and we also correct a number of misconceptions

regarding sustainable investing.

I hope you will enjoy reading this publication and I would like to invite

you to enter into a dialog with us about the challenges that we face as

investors in corporate bonds.

Edith Siermann

Chief Investment Officer Fixed Income

Challenging trends and opportunities in corporate bonds | 3



Decreasing liquidity is changing the marketIn recent years, investors in corporate bonds have been confronted with

decreasing market liquidity. This is mainly attributable to the changed

attitude of investment banks. Banks have become more cautious due

to the financial crisis and have therefore reduced their corporate bond

trading activities. In addition, banks are maintaining higher capital ratios

because of stricter regulations. They trade less often for their own account

and focus mainly on bringing buyers and sellers together.

Patrick Houweling, senior quantitative researcher and fund manager of

the Robeco Quant High Yield Fund, concludes that the reduced liquidity

could cause problems for investors in passive funds. “The credit market

has grown significantly in recent years, also because of the increased

popularity of ETFs. In normal market conditions, ETFs can be traded quite

easily. However, when markets turn and corporate bonds go out of favor,

investors can be unpleasantly surprised. Passive funds typically mirror

their underlying index. As a consequence the fund managers must sell

and buy certain bonds regardless of market conditions. When adverse

market conditions prevail and a large number of investors wish to sell

bonds without finding enough buyers to match supply, this may cause

the investments in the ETFS that are based on full replication to be sold

considerably below their net asset value. This applies mainly in turbulent

markets.”

The liquidity pitfall of passive investing

Investing in ETFs can be very risky, especially during periods of limited liquidity.

Patrick Houweling and Victor Verberk explain why and how active management and

the use of derivatives can provide both a solution and an investment opportunity.

-2.0%

-1.0%

0.0%

1.0%

2.0%

98

99

100

101

102

103

104

Premium/discount Market Price Net Asset Value

Source: Robeco, Bloomberg

15-0

4-12

22-0

4-12

29-0

4-12

06-0

5-12

13-0

5-12

20-0

5-12

27-0

5-12

03-0

6-12

10-0

6-12

17-0

6-12

24-0

6-12

01-0

7-12

08-0

7-12

15-0

7-12

Uncertainty about Greece brought the price of the high yield tracker below the net asset value

Active management avoids crowding at the exitVictor Verberk, co-head of the credit team, says that when investors opt

for active management they will no longer have to worry about executing

orders in unfavorable market conditions and avoid crowding at the exit.

“Managers of actively managed funds have various buttons that they can

press. First of all, as a fund manager you can seek to profit from market

movements. It is often unwise to sell during periods of market stress.

Markets often overreact. This is mainly due to parties such as ETFs that

are obliged to replicate their benchmark. Active management allows you

to capitalize on this situation. If you would like to reduce the size of your

portfolio, you can use that moment to sell less attractive bonds and – vice

versa – if you are enlarging your portfolio you can buy additional expected

outperformers. You must have the courage to trade contrarily. As an active

investor, you can thus profit from forced buying and selling by passive

funds. In fact, you can collect the premium that they need to pay.”

‘As an active portfolio manager, you have more buttons that you can press’

‘In turbulent markets, ETFs are sometimes sold far below their net asset value’Houweling illustrates this with an example: “Corporate bonds were under

pressure in May 2012 due to the uncertainty about Greece. The market

price of a corporate bond fund normally lies above its net asset value.

However during that period, the market price of the iShares-tracker in

European high-yield bonds was up to 89 basis points lower than its net

asset value. The reverse is true as well as this could also work the other

way around when passive fund managers need to buy in buoyant markets

conditions. In that case, they will pay too much for the bonds they need to

replicate their index. This occurred in July 2012.”



“A second advantage of active management is that you can maintain a

somewhat larger cash position. A lack of liquidity in the market is not a

problem if you do not necessarily have to sell or buy immediately. The

cash position makes this possible. Furthermore, you can reinvest the cash

in bonds that are liquid at any moment.”

According to Verberk, the third button which the fund manager can press

is the composition of the portfolio. “Actively managed funds can deviate

from the chosen benchmark. Not only does this provide flexibility, it can

also lead to an advantage in stressful markets. In June 2013, when there

was unrest in connection with the Fed policy, we were able to sell triple-A

asset backed securities relatively easily.

Finally, you can also make use of credit derivatives in the portfolios. These

are generally more liquid than bonds issued by the same company.”

Making use of liquid credit derivativesHouweling has recently been appointed manager of a fund that

predominantly invests in credit derivatives. “The Robeco Quant High Yield

Fund is a very liquid solution to invest in credits. The portfolio consists

of credit default swap (CDS) indexes, which are much more liquid than

individual corporate bonds. This is very appealing from a risk perspective.

Due to the absence of an illiquidity premium, CDS indexes suffer much

less in bear markets. Another advantage is that CDS have a ‘bullet

structure’. This means that, unlike many high yield bonds, they cannot be

redeemed in advance. This is a positive feature for the return potential of

CDS.”

“Because of the high liquidity of the CDS indexes, you can actively

and cheaply position the portfolio to profit from market trends. The

fund uses a proven quantitative model, which we have used now for

many years, to vary the beta of the fund between 0.5 and 1.5. Such a

quantitative investment style offers diversification for investors in addition

to fundamentally managed funds. Moreover, the fund is interesting for

investors with a tactical investment view. For these investors, who would

like to implement their investment view actively, the large degree of

liquidity and the low costs are very favorable.”

Houweling concludes that liquidity in the corporate bond market does

not have to be a problem. “Active management and the use of derivatives

offer both a solution and an investment opportunity.”

‘With CDS indexes, you can profit from market trends at lower costs’



Basel III Basel III, which came into force on 1 January 2014, obliges banks to

have higher levels of core capital, specifically Common Equity ‘Tier-1’.

The expectation is that banks’ capital buffers will increase further in the

coming five years.

The stress test for EU banks has raised the bar significantly. The European

Banking Authority on April 29, 2014 said banks will need to show they

have enough capital to be able to survive a worst-case scenario. This

entails: a 7% drop in GDP, a 14% fall in house prices and a 19% decline in

equity prices. These are far more stringent criteria than those of the 2011

stress test, which only allowed for a 0.5% fall in GDP. The real economic

contraction in the recession that followed was higher than that.

“The stress test seems to be fairly harsh, but we do not expect that there

will be many banks with capital shortfalls. We think that most banks which

had potential problems have issued equity already,” says Jan Willem

Stricter rules, new solutions

Increased regulation for banks and insurers, implemented in the wake of the financial crisis, is changing

the landscape for pension funds and other professional investors. But Basel III and Solvency II also present

opportunities in fixed income, particularly in the shape of new hybrid bonds and low-volatility credits.

de Moor, portfolio manager of the Robeco Financial Institutions Bonds

fund. “So we expect that the confidence in the banking sector will further

increase because of the stress test.”

Basel III forms part of a wider banking union and the introduction of the

Single Supervisory Mechanism, where the European Central Bank will

take over bank supervision from November 2014 onwards. The banking

union envisages a common EU policy, a single pan-European supervisory

mechanism, a deposit guarantee scheme and a resolution mechanism

that would recapitalize or liquidate failing banks in a structured way.

Basel III is providing interesting investment opportunities related to

financial sector credits. In future, existing ‘old style’ Tier 1 bonds will

no longer comply with the Basel III regulations. These will therefore be

replaced by a new type of bond (additional Tier 1) which offers a bank

more safety options if they get into trouble. Several hundreds of billions

of euros in new bonds are expected to be issued in the coming years. This


will replace existing Tier 1 bonds once they reach their call date. Banks are

also expected to continue issuing subordinated Tier 2 paper for general

funding. This will offer huge investment opportunities.

In the early stage of bank refinancing, capital was created in the form of

‘contingent convertibles’, or CoCos. The CoCo element can be added to

Tier 2 bonds or even senior bonds. CoCos have a trigger mechanism for

emergency measures dependent on the bank’s core capital level falling

beyond a specific level. Banks may then skip coupon payments to save

money – which means investors run the risk of losing interest income – or

convert the bonds into equity. The bond could also be wholly or partially

written off. As these bonds are riskier and more complex than traditional

bonds, a higher level of investment expertise is necessary.

“We buy CoCos if we think that the capital reserves are sufficient and if

there is only a very, very small chance that the bank’s core capital will

reach the trigger level. The risk of conversion is then considered a tail

risk,” says De Moor. “We look at the quality of the banks as well as the

bond’s specific characteristics, including the trigger for potential write-

downs or coupon deferral. In addition we consider the bank’s business

profile, to see how volatile their earnings are likely to be.”

Solvency II When Solvency II comes into effect, insurers will also need to have higher

capital buffers against the risks they run. The slow legislative process

in finalizing the framework’s details has led to its implementation date

being postponed until at least January 2016, but most insurers have

already taken the necessary steps in anticipation of these changes.

Insurers will be obliged by Solvency II to hold enough capital to cover

the risk of their investments, while they also try to raise returns for

policyholders. The Catch-22 problem here is that yields on safe sovereign

bonds are at historical lows, requiring investors to look at higher-yielding

products such as credits. This raises the risk profile of their holdings

requiring more capital to act as a buffer.

Robeco’s Conservative Credits strategy is based on the ‘low-risk anomaly’:

over the long term lower-risk bonds have consistently performed better

than bonds with higher risks. This means that the Sharpe ratios of low-risk

bonds have been consistently higher.

Solvency II capital requirements have been calibrated on historical

volatilities, which implies that a Conservative Credits portfolio not only

delivers superior returns per unit of risk, but also per unit of Solvency II

capital.

“Solvency II looks as if it could have been designed for Conservative

Credits. Insurers can use it to invest in a strategy with low risk and less

Solvency II capital, while generally being able to earn the needed returns

for their clients,” says portfolio manager Patrick Houweling.

“The strategy is perfectly situated between AAA-rated government bonds,

which are very safe but offer low yields, and general credits, with higher

yields but also substantially higher risks.”




Benefits from a flexible, integrated approachMost institutional investors allocate capital to specific asset classes,

segments, sub-categories and then specific managers. For credits this

includes segments such as high yield or investment grade, or sub-

segments such as Asset Backed Securities (ABS) or covered bonds.

It has been a modus operandi for decades, but this kind of ‘box-ticking

exercise’ remains an inflexible approach. Now a trend has emerged to use

flexible strategies which can allocate more freely, and are more diversified

and globalized. Essentially, such a fund-building exercise benefits from

being able to access all available opportunities across various credit

segments.

This is more flexible than a traditional approach where changing

allocations may require a new manager selection process, extra red tape

and transaction costs. At the same time, institutional investors should

be mindful about the cost effectiveness of flexible integrated strategies

as well, since excessive switching between credit segments will also be

expensive.

Flexible strategies to benefit from relative value trade-offsNew flexible credit strategies offer institutional investors market segmentation benefits through one integrated

approach. This article explains the benefits and the rationale.

When using this flexible integrated approach, it becomes possible to look

for relative value trade-offs within the whole credit universe, for instance

in using ABS instruments versus covered bonds, or high yield subordinate

securities versus investment grade paper. The goal of making the right

relative value trade-offs is to achieve higher returns via a broader set of

opportunities.

What are the main drivers behind this trend? Victor Verberk, head

of investment grade credits at Robeco, highlights three underlying

rationales.

Rationale 1: Desynchronized cyclesThe flexibility of an integrated credit strategy is increasingly required as

central bank policies continue to desynchronize and as different credit

markets reprice securities as their economies and companies improve at

different rates. Desynchronized cycles lead to dispersed monetary policies

and different interest rate environments across the globe, making it

increasingly important to avoid a local bias.


Desynchronization has led to opportunities to switch between the

traditionally separated developed and emerging credit markets.

The current compressed difference between high yield and investment

grade offers fewer opportunities.

“As we are now quite late in the credit cycle, bonds are becoming more

expensive and sometimes more rate sensitive”, says Victor Verberk. ”It’s

now ideal to be able to jump between segments and not be constrained

by boundaries.”

“For example, in the last 12 months emerging credits have significantly

underperformed developed markets because rate fears from the Fed have

been prevalent since June 2013. And now, developed markets may start

underperforming.”

“So if you are flexible and not restricted by segmentation strategies you

can switch from developed to emerging markets, where many corporate

bonds are now repricing. Or, if you anticipate that the Fed will increase

interest rates much sooner and more aggressively than the market

expects, you can switch into government bonds or ABS, which can

outperform unsecured credit.”

You can also benefit from desynchronization if you take a wider, more

integrated view, he says. “For a few years investors were long Europe

versus the US and that worked perfectly well at the time. Now, due to

rate risks, the US credit market will become more volatile. Emerging

markets have already repriced, and that makes global positioning more

important.”

Rationale 2: Changing perceptions of riskVerberk says one problem with continuing the traditional allocation by

institutional investors is that perceptions of risk have changed since the

financial crisis of 2008-09, and some bonds that appear ‘safe’ have

become much more expensive, making quality risk-adjusted returns

harder to come by.

“If everything is over-compressed in certain areas, then it looks safe, but

it is expensive and can be misleading,” he says. “A high yield bond with

a spread of 1,000 basis points over a sovereign bond can be safer than

something that is 300 basis points over. You need the expertise to know

what is really worth owning.”

Many institutional investors still provide mandates that require a strict

split between all these segments. What can make matters worse is that

regulators sometimes press for even less flexibility within mandates. This

ensures that flexible, integrated funds will retain their benefits for the

years to come.

Rationale 3: Benchmark disadvantages Another problem with the traditional allocation towards specific segments

in combination with very specific benchmarks is that there is a greater

chance they will include high risk securities an investor may want to avoid,

such as unhealthy banks. “The smaller your universe is, the more you

become obliged to invest in anything that’s in the index, and your chance

of having bad luck with exposure to a company with a very high default

risk is bigger,” says Verberk. “With a global view it is easier to find the best

ideas.”

Robeco’s new Global Credits fundRobeco’s new Global Credits fund offers the flexibility of an

integrated strategy. The fund invests in the best-of-class credits

across all asset classes regardless of type or location, and does

not follow a benchmark. Since the Robeco credit team has

a composite record, there is a three-year track record available

for a similar strategy as the one for the new fund.

To make such a global strategy work, a large and experienced

team is required to be able to pool individual specialties and

enable the fund manager to get the best of all worlds under

one roof. “We have a big credit team now of more than twenty

people including expertise in emerging credits, high yield,

investment grade and secured finance within one integrated

team. It is ideally equipped to come up with all the best ideas in

all the market segmentations,” says Verberk who is the portfolio

manager of this fund.

Verberk serves on many of Robeco’s 500 credit committees,

getting the best possible overview of all segments and regions.

“It means I can go across the teams and see everyone’s ideas. If

for example there is a credit that is BB and is about to cross over

into investment grade, one of the team members can spot it and

alert me. I do the same for coming fallen angels for the high yield

specialists. It is a flexible approach for a flexible strategy,” he says.

This lack of bias is used to investors’ full advantage. “The

biggest benefit of being global is the ability to have global ideas

generation,” says Verberk. “The breadth of our ideas is bigger as

the global market is almost endless and there is always a good

risk/return out there.”

“We typically have a research driven investment process with a

somewhat longer investment horizon. The overwhelming amount

of ideas comes from our own research. This way trading costs are

limited. We prefer old-fashioned bonds with a prospectus and no

counterparty issues, to derivatives. However, for short positions or

overlay strategies, derivatives are very efficient.”




Increasing financing requirementDue to a significant increase in prosperity and more social security in

emerging markets, households have started to consume more and

make use of credit. This often concerns short-term loans, for example, to

purchase household goods or a car. However, a market for mortgages and

long-term loans is also starting to arise. In order to ensure that the supply

increases in line with the demand for goods and services, companies

have been investing in production capacity, infrastructure and real estate.

Consequently, a structural increase has also occurred in the demand for

loans among companies in recent years.

This rapid growth of corporate loans and consumer loans has caused

the total debt of emerging countries to be more evenly spread between

the private and public sector as the debt of the public sector has grown

a lot less rapidly. These economic developments have stimulated the

development of capital markets.

More diversification with emerging economies

The beginning of the 21st century was characterized by a strong increase in global trade, relocation of

production from developed to emerging countries and an unprecedented demand for natural resources.

This resulted in a period of more than ten years of uninterrupted economic growth in emerging countries.

Capital markets for emerging markets are rapidly maturingPrior to 2000, the governments of emerging countries could practically

only borrow in hard currencies such as the dollar or the euro. As a result

of the increased stability in the past years, investors are now more often

willing to lend to governments in local currencies.

The emergence of a market for corporate bonds is the next step. The

market for corporate bonds from emerging countries is developing

extremely fast. The market has grown in the past five years from USD 340

billion to more than USD 1.4 trillion today . This investment category is

thus already bigger than, for example, the US high yield market.

The credit market was initially dominated by large state-owned

companies in specific sectors such as oil and gas or banks. However,

more diversification has occurred in recent years with companies for

the consumer sectors such as IT or retail. The trend in creditworthiness


has also been positive. In 2014, approximately 70 percent of the issuing

companies has an investment grade rating.

The dynamics of emerging creditsDue to an unprecedented availability of international capital and the

growing demand for loans, more and more companies are seeing the

advantages of establishing long-term relationships with investors.

Companies are increasingly willing to adapt their reporting standards and

governance to the wishes of western investors in order to obtain access to

international capital.

As a result of the rapidly growing number of ‘new’ companies, the

emerging credit market is under-researched. This provides many

opportunities for investors. The fact that this segment is under-

researched, also provides extra opportunities for active managers such

as Robeco, to prove their added value by realizing outperformance.

However, there is also another side to the coin. Not all companies are

fundamentally healthy and, in some cases, investors are insufficiently

protected. This demands a new approach. Not only the company or the

country itself must be carefully analyzed. The influence of a country on a

company and the importance of a company for a country are particularly

relevant criteria. On the one hand, for instance, government intervention,

corruption or legislation can impact a company. On the other hand,

there is the importance of a company as, for example, a country’s energy

supplier. By comparing companies worldwide within a sector and taking

the country risk into account in the analysis, the quality of each company

can be placed in a clearer perspective.

1 Source: JP Morgan Emerging Markets Reference Presentation March 2014

Opportunities for institutional investorsCorporate bonds from emerging countries offer the possibility to obtain

direct access to themes such as ‘the emerging consumer’ without the

volatility of equities or currencies. Moreover, this new market offers

the possibility to increase the diversification in an investment portfolio.

Economic cycles in emerging countries often differ from the cycles in

Europe and the United States. In addition, this market offers a large

number of new companies to invest in. Therefore, it is not surprising that

investors are becoming increasingly interested in this market. In 2011,

Robeco decided to build up expertise in corporate bonds from emerging

economies in addition to its emerging equities strategies

Robeco Emerging CreditsRobeco manages the Robeco Emerging Credits fund based on a

total-return approach. This is a fund that focuses specifically on

corporate bonds from emerging countries. Of course, we also

offer institutional investors the possibility to participate in this

rapidly developing investment category via a mandate structure.




A smarter way to harvest factor premiums

Scientific research1 in equity markets shows that investing based on factors

results in an improvement of the Sharpe ratio of portfolios in the long

term. Well-known factors are Low-risk (low-volatility stocks), Value (stocks

with a low price/book ratio), Momentum (stocks with a high return over

the past twelve months) and Size (small companies). These factors are

also referred to as anomalies because their returns cannot be explained

with traditional investment theories. Research carried out at the request

of the Norwegian Government Pension Fund showed that the largest part

of the active return of this fund could retrospectively be attributed to the

exposures to these factors.

Better Sharpe RatioBasing its approach on factor investing in equities, Robeco carried out

research into the construction of corporate bond portfolios using the

following factors: Value, Momentum, Size and Low-risk. Martin Martens,

Head Quantitative Fixed Income Research at Robeco: “Our research

shows that investing based on factors results in a better Sharpe ratio

than investing in the whole market index. This applies to both investment

grade and high yield. So factor investing indeed works for credits.” This is

illustrated in the figure below.

According to Patrick Houweling, Quantitative Credits portfolio manager

and researcher, the challenge is to use a definition for each factor that

Factor investing is often only associated with equities. Scientific research shows that focusing on the characteristics (‘factors’)

of equities results in an improvement of the risk-adjusted return. However it is less well known that factor investing also

works for credit portfolios. Our research in credit markets shows that investing based on factors results in a better Sharpe

ratio than investing in the market index.

1 See also: Fama & French (1992), “The Cross-Section of Expected Stock Returns,” The Journal of Finance; Jegadeesh & Titman (1993), “Returns to

Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” The Journal of Finance; en Blitz & Van Vliet (2007), “The Volatility Effect:

Lower Risk without Lower Return,” The Journal of Portfolio Management.

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

Market Value MomentumInvestment Grade

Size Low Risk Market Value MomentumHigh Yield

Size Low Risk

Generic definitions Smart definitions

Sharpe ratio factors

is specific for credits and not to just ‘simply’ copy the equities definition.

“For example, the objective for Value is to determine whether a

company’s credit spread is too high or too low and not whether the shares

are expensive or cheap. For ‘credits Value’, the trade-off is generally

between the market estimate of the risk - the credit spread - and the

objective risk as for example estimated by a rating agency. Another

example: for the low-risk factor for equities historical volatility is often

used. For credits, the maturity and the rating are generally regarded as

generic risk measures: the longer the maturity and the lower the rating,

the riskier the bond.

Smarter definitionsIn addition to a generic definition of each factor, Robeco also uses a

‘smarter definition’. Robeco examined whether the Sharpe ratio of the

general definition could be improved by estimating risks more precisely

or avoiding unnecessary risks. Martens: “For Value, instead of looking

at ratings, you can look at theoretical credit risk models that combine a

company’s balance sheet information, such as leverage, and a company’s

equity information, such as its volatility, in a smart way.” Houweling: “You

can construct a low-risk portfolio by avoiding the longest maturities and

the worst ratings. This already results in a better Sharpe ratio than the

market. However, we have found smarter risk measures than ratings. Our

study shows that a better Sharpe ratio can be achieved for each factor

than with the generic definition.”

Low-risk creditsAnalogously to low-risk equity investing, Robeco developed a strategy two

and a half years ago for low-risk corporate bond portfolios. Houweling:

“Our empirical research shows that, in a full investment cycle, low-risk

corporate bonds have the same return as ordinary corporate bonds,

but with a 50% lower volatility. This results in a better Sharpe ratio.

The key is that you implement the low-risk factor by investing in low-

risk bonds of low-risk companies.” Martens lists three rules of thumb

for the implementation: avoid unnecessary risks, do not go against

other anomalies and avoid unnecessary turnover. Martens: “Avoiding

losers is more important than selecting winners. In addition, you can

decrease risks by constructing a diversified portfolio. Do not select Source: Robeco



companies only based on Low-risk characteristics, but also make use of

Value and Momentum. And finally, opt for a buy and hold strategy to

avoid unnecessary turnover and high transaction costs, and to earn the

illiquidity premium.

Fundamental checkIn addition to quantitative analysis, fundamental analysis by the Credit

Team is also important in order to monitor non-quantifiable risks that are

difficult to capture in a model. What does the structure of the company

look like? Has the parent company issued a guarantee for the entity that

issued the bond? Did the management announce a planned acquisition

that will result in higher leverage? How does a company score on ESG

criteria, such as sustainability, labor conditions and the quality of the

management? Houweling: “These types of risks are not reflected in the

existing balance sheet data. Our analysts identify the non-quantifiable

risks timely and thus help further reduce the risk of the portfolio.”

Robeco Conservative Credits Within Robeco Conservative Credits, the low-risk factor is

implemented by investing in a disciplined manner in low-risk

bonds of low-risk companies. Conservative Credits is being

applied in various mandates with a total size of EUR 2.6 billion as

at the end of April 2014. Robeco is currently carrying out research

into the implementation of other factors in disciplined strategies.

For more information visit www.Robeco.com/conservative-credits



ESG integration, in particular for corporate bonds

As an illustration: there are simply no longer any Requests for Proposal

without questions about ESG (environment, social and governance). And

the assets that are managed by organizations that have signed the UN

Principles for Responsible Investment (PRI) have risen from USD 4 trillion

at the introduction in 2006 to USD 34 trillion in 2014. This represents 15%

of global assets available for investment. In addition, the signatories of

the PRI have to comply with increasingly strict requirements.

The many interpretations of sustainabilityThere is general consensus now on the fact that sustainable investing is

not simply a hype that is going to blow over. Although most institutional

investors no longer regard this as a ‘green’ or ‘ethical’ strategy, there are

still a large number of interpretations and implementations, varying from

excluding weapons manufacturers to a way to manage long-term risks.

Robeco helps pension funds to develop their convictions, ambitions and

policy in the field of sustainability. In addition, we implement this policy

by integrating sustainable investing in the existing investment policy or by

offering voting and engagement services. We can also screen portfolios

on sustainability and provide a detailed report on this.

The integration of sustainability in credit investmentsRobeco applies complete integration of ESG factors in all credit strategies.

Besides a company’s competitive position, strategy, financial position and

structure, ESG is one of the five pillars of the credit analysis. We do this

because we are convinced that ESG factors provide additional relevant

information so that we are better able to analyze a company and to limit

the downward risk of investment portfolios. The weight of the ESG pillar

in the total analysis depends on how financially material this is. There are

a large number of ESG indicators for each company and we only analyze

the ESG aspects that are the most relevant for the company’s financial

position and profitability.

Institutional investors are becoming increasingly aware of the fact that trends such as population growth, the scarcity of raw

materials and globalization have an impact on a company’s risks and opportunities. Under the pressure of regulators and investors,

such as participants in pension funds, sustainable investing is slowly but surely evolving from a ‘niche’ to a general trend.

‘There is general consensus now on the fact that sustainable investing is not simply a hype that is going to blow over’

Focus on limiting riskThe Corporate Sustainability Assessment (CSA), or the sustainability

scores of RobecoSAM, Robeco’s sustainable investing subsidiary, is based

on surveys held among approximately 2800 companies and plays an

important role in the credit process. These scores are discussed by the

credit team with the specialized RobecoSAM sustainability analysts. We

mainly focus on negative elements such as weak spots in the corporate

governance or in the environmental policy. In addition, we supplement

our research with other sources that can expose even more risks. For

example, we scan the media to see if the company is involved in legal

proceedings or settlements. After all, the amounts involved in issues like

this can have a substantial impact on the company’s financial position.

Is sustainable investing expensive?At Robeco, we look at ESG from a financial perspective. Return is the most

important issue for us. It is a myth that ESG integration is at the expense

of return. Many questions in RobecoSAM’s CSA concern financially

material issues such as governance, risk management, personnel policy

and other factors that ultimately also affect a company’s profitability. ESG

analysis enables us to take better informed decisions and to pick up risk

signals in an early stage. This way, we are able to avoid the losers.

Unique: an active dialog with credit issuersAnd we go a step further than just analysis. A team of engagement

specialists enters into an active dialog - engagement - with selected

companies about financially important themes that are determined

in consultation with portfolio managers, investment analysts and

sustainability analysts. That this not only takes place for equities but also

for credits is unique. We encourage companies to take concrete steps

to improve their sustainability, as this also has a positive effect on their

creditworthiness.

An example is our engagement with the Brazilian energy company

Petrobras. Petrobras subsidizes gas prices by purchasing at the market

price and selling under the market price. As a result, the company

has a large influence on the inflation rate. The chairman of the board

of Petrobras is also the Brazilian Minister of Finance and therefore

the company’s independence is doubtful. Together with a number of

institutional investors and in cooperation with our credit analysts, our

engagement analysts proposed two independent members of the Board.

This proposal was approved by the shareholders, which has resulted in a

considerable improvement in the company’s corporate governance.



Exclusion also excludes improvementIt is exactly because we believe in a constructive dialog that we

only exclude companies if there is no other option, for example, if

they structurally violate the principles of the UN Global Compact or

manufacture controversial weapons. The most important objection to

exclusions – especially exclusions on the basis of conduct – is that as

an investor you then deny yourself the opportunity to exert a positive

influence on the operations of the company in question. We believe in

long-term relationships with companies – a positive approach in which

we try to convince a company that improvement is also in its own interest.

Moreover, we are convinced that a company that has an answer to today’s

challenges in the field of the environment, society and good governance,

offers better prospects and entails fewer risks and is therefore more

attractive for credit investors.

‘A company that has an answer to today’s challenges in the field of the environment, people and good governance, is more attractive for credit investors’

‘It is a myth that ESG integration is at the expense of return’


16 | Challenging trends and opportunities in corporate bonds1138_E-08’14

Important informationRobeco Institutional Asset Management B.V. (trade register number: 24123167) is licensed by the Netherlands Authority for the Financial Markets (AFM)

in Amsterdam. The Spanish branch Robeco Institutional Asset Management B.V., Sucursal en España is licensed by the Spanish Authority for the Financial

Markets (CNMV) under register number 24. All funds in this publication are UCITS and authorized for the commercialization in France by the AMF. Any

investment is always subject to risk. For the risk factors of the funds in this publication, you need to read the prospectus, the (semi)annual reports and

the Key Investor Information Document. All these documents can be obtained free of charge at www.robeco.com. This publication is for professional

investors only.

In Germany

This information is solely intended for professional investors or eligible counterparties in the meaning of the German Securities Trading Act.

The information contained is only intended for the addressee and must not be forwarded without the prior consent of Robeco.

In Japan

This material has been prepared by Robeco Institutional Asset Management B.V. for informational purposes, should not be considered as a solicitation

or a recommendation to trade any particular financial products mentioned within. We believe that the information provided herein is reliable, but do

not guarantee its accuracy or completeness. Opinions, outlooks and estimates offered herein constitute our current judgment and are subject to change

without notice. The statements concerning investment status, market overview, and other comments are made with respect to particular points in

time or periods in the past, and past performance is not a guarantee or a reliable indicator of future results. The strategies described herein may not be

suitable for all investors. This material is not intended to provide, nor should it be relied on for legal, tax or accounting advice. Please seek professional

advice, as appropriate, prior to making any investment decision. The value of assets under management will be affected by, and fluctuate based

upon, movements in prices of securities in the portfolio, financial market conditions, interest rates, and credit risk arising from changes in the financial

condition of issuers of securities in the portfolio, among others. Where investments are made in foreign currency denominated assets, the value of the

assets will also be affected by movements in foreign exchange rates. All profits and losses resulting from investments are for the account of the investor.

Thus, there is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; rather, the investment

could suffer a loss of exceed the amount invested. The fee charged for our activities related to the financial instruments business will vary depending

on the type of agreement entered into and the amount of assets contracted, and thus we may provide descriptions of such fees separately, rather

than describing such fees in this material. In such a case, please contact with Robeco Japan Co.,Ltd account manager for specific fee amounts or their

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This document is for professional investors only. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you

are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by

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Robeco Institutional Asset Management B.V. (trade register number: 24123167) is licensed by the Netherlands Authority for the Financial Markets (AFM)

in Amsterdam. The prospectus and the Key Investor Information Document for all the funds in this publication can be obtained free of charge at

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© Robeco 2014C011996


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