Factor Investing in Volatile Credit Markets
Factor-based credit strategies use a rules-based approach for security selection, investing in the best issuers ranked on metrics such as balance sheet quality, current valuations and recent price momentum. The goal is to deliver improved risk-adjusted returns, particularly in periods of market stress, by improving issuer selection via a systematic and transparent process.
To test how factor-based credit performs in volatile markets, we looked at performance through the Covid crisis of the first half of 2020. We focused on three areas: the overall returns recorded by factor-based credit strategies; the performance of individual credit factors; and the ability of factor investing to avoid credit tail risks.
Evaluating returns from factor-based credit strategies in the Covid crisis
We measured the overall performance of factor strategies by comparing the absolute return of the ICE Global High Yield Index with the relative excess return of the J.P. Morgan Asset Management Global High Yield Multi-Factor Index, focusing on four distinct periods between January and June 2020.
We can see that in Period 1 (relative normalcy), markets were modestly positive in the lead up to the coronavirus outbreak, as were factor excess returns. However, in Period 2 (market drawdown), factor investing added value as markets sold off rapidly in reaction to the Covid-19 economic shutdowns. Factor investing tends to do well in periods of market stress, particularly when there is more dispersion in the performance of different issuers.
In Period 3 (rapid stimulus-driven rally), factor strategies struggled as markets were driven by government intervention and unprecedented central bank stimulus. Factor investing tends to struggle in liquidity-driven or technical-driven rallies. Finally, in Period 4 (return to normalcy), factor-based credit strategies produced flat returns as markets stabilised before continuing their positive trend.
Individual factor performance
When we consider performance over the first six months of 2020 at an individual factor level (quality, value, momentum), the results are relatively intuitive.
The quality factor in credit markets considers metrics such as a company’s leverage, profitability, and overall balance sheet strength. As one might expect, the quality factor outperformed in the market drawdown but lagged in the market rally.
The value factor in credit markets considers a bond’s relative cheapness, allocating to issuers with higher spreads relative to their fundamental value. These higher-spread names underperformed in the market sell-off, but added value in the subsequent rebound.
The momentum factor considers an issuer’s recent price change, across both equity and credit markets. The pattern in this factor was slightly less clear given the speed of the market moves. In general, momentum was flat through the drawdown, though negative during the subsequent rally given the pace of the turnaround.
Avoidance of rail risks
Factor-based investing evaluates issuers based on their fundamentals and selects securities with the strongest relative multi-factor score. This approach has benefits: for example, backtests suggest factor strategies have been good at avoiding high-risk issuers, such as potential fallen angels (issuers downgraded from investment grade to high yield) and defaults.
We take a multi-factor approach to investing in credit markets to limit turnover and drawdown. This year, there have been around 50 issuers downgraded to high yield across developed markets. Our factor-based credit strategy avoided nearly all of them.
Similarly, across global high yield markets, there have been around 30 defaults, and our multi-factor strategy avoided more than 90%. Given expectations that default rates will rise, this is something to continue to monitor over the next six to 12 months.
Factor-based strategies can improve risk-adjusted returns
In the unprecedented sell-off and rally seen in the first half of 2020, factor-based strategies performed as designed: outperforming during the drawdown, though lagging in the liquidity-driven rally.
We believe that a transparent, multi-factor approach to issuer selection has the potential to provide improved upside/downside capture through the market cycle, helping investors diversify their credit exposure and improve risk-adjusted returns.