Credit Factors: Strong Performance in Turbulent Times
- Credit factor performance was robust during Q1 across regions with outperformance in developed and emerging markets.
- Global high yield (HY) credit factors outperformed the ICE BofA Global HY Index by 1.8% in Q1, the strongest quarter since the global financial crisis.
- Both momentum and quality factors were additive in Q1, while value detracted from the performance.
Brief Introduction to Credit Factors
Factor investing relies upon a rules-based approach to buy or sell securities. The concept of factor investing in equities is supported by decades of academic research and out-of-sample empirical results across a range of geographies and time periods. While factor-based investing in equities markets has been common, systematic style factor investing in fixed income is relatively new both in academia and the asset management industry. Credit factor scores are not only useful as systematic signals for securities selections, but they are also an excellent tool for portfolio analysis to identify potential style biases.
In addition to market factors such as term and credit-risk premia, our GFICC Quantitative Solutions (QS) team focuses on credit style factors. Our preferred factors – quality, value, and momentum - are complementary to market factors. On the basis of rigorous back-tests and low correlation among each other; quality, value and momentum are value-additive factors in fixed-income investing:
Quality relates to the strength of the balance sheet. High-quality companies are profitable and have a high likelihood of repaying their debt. Through a cycle, high-quality credits tend to generate higher risk-adjusted returns than companies with weak balance sheets.
Value is best explained by the tendency of cheap securities to outperform more expensive securities over time. Cheap securities are chosen to have a high market measure of credit risk (credit spread) relative to a fundamental anchor such as default probability.
Momentum is the tendency of persistence in recent relative performance: companies with strong recent performance tend to outperform the ones with weak recent performance.
In summary, credit factors are quantitative scores that are used in a systematic way to exploit credit style premia.
Credit Factors: Strong Performance in Turbulent Times
During Q1 2022 the ICE BofA Global HY Index declined by 6.0% on the backdrop of geopolitical tensions and inflation concerns, while credit factors outperformed the market weighted benchmark by 1.8% during the same time period.
As a first step in constructing credit factor Portfolios we align systematic characteristics of a strategy to those of the underlying benchmark: neutral in the term and credit risk premia as well as region/sector dimensions. As a result, the majority of the excess return in credit factors is driven by issuer selection. Figure 1 shows the multifactor excess returns over the market-weighted index as well as the single factor contributions.
As can be seen from the chart, the momentum factor was the biggest contributor to the multifactor outperformance during the quarter. In other words, companies that had been underperforming in previous quarters continued to underperform in Q1, and hence, avoiding such companies was a positive contributor to the overall multifactor performance. Additionally, companies with strong relative recent performance exhibited lower beta to the overall market, resulting in significant outperformance vis-à-vis the benchmark. Companies that scored well on our quality factor, those with strong fundamentals and low market beta, outperformed in the quarter. Our value factor, companies with high default-adjusted credit spreads and high market beta, underperformed during Q1.
The negative correlation between the quality and value factors shown in Figure 1 demonstrates why multifactor credit investing generates robust returns through time. This low or even negative correlation has been observed through history. Standalone single factors can have extended periods of underperformance. This is the main reason why the single factors are selected and constructed to have relatively low correlation amongst each other. Therefore, combining the single factors into a multifactor approach has the advantage of a more robust performance through time with shorter periods of underperformance. The marker in Figure 1 shows the aggregate credit factor excess return over the benchmark. Since the beginning of 2020, the Aggregate Multifactor has had seven quarters with positive performance and only two quarters with negative performance.
Robustness in multifactor sector return is not only experienced in the global context, but also across developed and emerging markets. Not surprisingly, emerging markets had the strongest performance versus their benchmark given the elevated dispersion in those regions.
Figure 1: Factor Excess Return vs Benchmark
Credit Factors: Historical Performance
By aligning a portfolio’s systematic risk (duration, DTS and sector allocations) with the underlying benchmark, issuer selection will play a bigger role during times of heightened dispersion. Periods of increased dispersion in the market have historically led to strong factor outperformance. Figure 2 shows the multifactor excess return versus the benchmark during historical periods of market stress and increased dispersion.
Figure 2: Factor Performance vs. Benchmark during periods of market stress
In the broader historical context, the first quarter of 2022 was the strongest quarter since the global financial crisis. Going forward we continue to expect strong credit factor performance based on elevated dispersion in the market on the backdrop of geopolitical and monetary policy uncertainty.