- Global high yield credit factors outperformed the ICE BofA Global High Yield Index by 1.6% in Q2, building on the strong Q1 performance.
- Both momentum and quality factors were additive in Q2, while value detracted from the performance. Factor performance was robust across regions, with USD, EUR and EM outperforming their debt-weighted benchmarks.
- Our analysis shows that credit factors are robust across different market and economic regimes for the past two decades, 2022 is another example of this robustness.
Credit Factors: Q2 2022 Performance
With continued elevated inflation and heightened concerns about a potential economic recession on investors’ minds, the ICE BofA Global High Yield Index dropped by another 11.4% during Q2. During this period, the credit factor strategy outperformed the benchmark index by 1.6%, continuing the trend we saw in the first quarter. Credit factors have outperformed by 3.1% on a year-to-date basis and by 3.5% for the trailing 12-month period. Second quarter performance was very robust across regions, with strong performance in developed USD and EUR, as well as EM markets.
In
Figure 1 we decompose the multifactor excess return over the benchmark into single factor contributions. Similar to Q1, albeit at a lower magnitude, the momentum factor continued to be the biggest contributor to the multifactor performance during the quarter. The momentum factor has had the most consistent performance across all factors since 2020. It delivered positive performance in all quarters except during the strong market reversal in the immediate aftermath of the Covid crisis. In continuance of the first quarter, companies that scored well on our quality factor (those with strong fundamentals and low market beta) outperformed in the quarter, and the value factor (companies with high default-adjusted credit spreads and high market beta) performed flat during Q2. For the trailing 12-month period both the momentum and the quality factors had strong positive contribution to performance with 2.6% and 1.5% respectively, while the value factor detracted 0.6%. In aggregate the credit factors added 3.5% in performance relative the ICE BofA Global High Yield Index over the past year.
Figure 1: Factor Excess Return Contributions vs Benchmark
Source: JPMAM GFICC Quant Solutions calculations; date as of 30th June 2022
Credit factor performance during different market environments
The credit factors are constructed in a way to outperform the benchmark over a full business cycle while removing the human biases and tendencies to over-react during times of distress. Below we analyze how different market environments affect the factor performance and how factors behave during different economic regimes.
In the previous section we discussed the strong factor performance during the past two quarters, periods in which the global high yield market significantly declined. Historically this has not been an isolated experience, since the global financial crisis, credit factors in global high yield markets have outperformed the debt-weighted benchmark in normal and declining market environments and underperformed during market rallies.
Figure 2 plots the global high yield factor outperformance over the benchmark relative to market spread changes. Since the global financial crisis, the figure shows that factor strategies tend to add value when spreads widen and underperform during periods when spreads tighten. We ran a regression analysis on the data, the results are presented in
Table 1. In the table, we show expected factor outperformance for different market spread changes from 200 bps spread tightening to 200 bps spread widening. The results show that credit factors tend to underperform the benchmark when spreads tighten, e.g., a quarter when the benchmark spreads tighten by 200 bps leads to an underperformance of 0.7%. In market environments that have unchanged or widening benchmark spreads credit factors are expected to outperform. During a quarter when benchmark spreads widen by 200 bps credit factors are expected to outperform by 0.9%. In the second quarter of 2022 the market spreads widened by about 210 bps, while credit factor outperformed slightly more than expected at 1.6%.
In other words, credit factors have positive alpha relative their debt-weighted benchmarks through the cycle. We show that there is a negative relationship between factor outperformance and benchmark performance with credit factors performing particularly strong during periods of market distress. The relationship is asymmetric, during market rallies credit factor underperform by less than they outperform during normal and distressed markets resulting in an overall positive alpha through the cycle.
Figure 2: Factor Outperformance vs Market Spread Changes
Source: JPMAM GFICC Quant Solutions calculations; date as of 30th June 2022
Table 1: Regression Analysis
This table shows the results of a regression analysis of the factor outperformance (over the benchmark) relative to quarterly benchmark spread changes for the sample period 2008-2022.
Source: JPMAM GFICC Quant Solutions calculations; date as of 30th June 2022
How do factor strategies perform during different monetary policy regimes?
Faced with the highest inflation in decades, the Federal Reserve has tightened monetary policy aggressively by 225 bps year-to-date with further quantitative tightening looking inevitable. A natural question to ask is how factor strategies historically performed during different monetary policy regimes. To extend the sample period we focus on the US high yield market in this section.
Figure 3 shows the US high yield factor strategy and its debt-weighted benchmark performance for the period of 2003 to 2022. During the full sample period, our backtest shows an annualized performance of 8.2% for the factor strategy and 7.3% for the benchmark. Credit factor strategies are designed to outperform the benchmark over the long term.
We analyze different monetary environments by splitting the sample period into three regimes: tightening, neutral and easing. The benchmark returns were positive during neutral and tightening regimes at about 12.2% and 5.6%, respectively. During monetary easing episodes, the benchmark had a significantly negative performance at about -8.1%. The monetary easing regime covers the two periods of biggest market distress during our sample period, the global financial crisis and the Covid crisis. These two episodes are responsible for the overall negative returns during monetary easing regimes in our sample period.
The factor strategies have on average outperformed in all three regimes. During the neutral and tightening regimes the annualized outperformance was 0.7%. For the monetary easing episodes the outperformance is significantly higher at 2.2%. The outperformance in the easing regimes is driven by months with high market distress, confirming the results we showed in the previous section. If we were to remove the height of the global financial crisis and the Covid crisis from the easing sample, the factor strategy has underperformed the benchmark by 0.6%.
In conclusion, high yield factors have historically performed well relative to their benchmarks over a full business cycle. Breaking down our sample period into different monetary policy regimes shows that the performance is robust across regimes. The year-to-date global high yield factor outperformance of 3.1% falls into a period where we have seen both corporate bond market distress and monetary tightening, both periods during which factor have historically performed well relative to their benchmarks.
Figure 3: Factor Performance during Monetary Policy Regimes
This figure shows the annualized credit factor and the benchmark performance for US high yield. We analyze the performance in different monetary policy regimes by partitioning the sample period (2003-2022) into easing, neutral and tightening regimes.
Source: JPMAM GFICC Quant Solutions calculations; date as of 30th June 2022
Appendix: 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.
