Credit Performance in the Summer of 2022
Despite rallying credit spreads, corporate bond managers on average underperformed in July 2022, while they outperformed in August 2022 despite rising spreads. What is behind this unusual performance pattern?
Dr. Harald Henke
Head of Fixed Income Strategy
Market moves in summer 2022
The summer months July and August 2022 were characterised by strong spread and interest rate moves. This was nowhere as present as in Euro investment grade (IG) credit. The following graph shows the development of Euro IG spreads and German interest rates over the last months.
Figure 1: Credit spreads and interest rates in summer 2022
In July, Euro IG credit spreads strongly rallied after the June widening, falling 31 basis points from 2.18% to 1.87%. In the first half of August, this rally continued with spreads tightening another 8 basis points to 1.79% before reverting this trend and closing 15 basis points higher compared to the end of July at 2.02%. Likewise, German ten-year interest rates displayed a strong performance in July falling 54 basis points to 0.82% but rose again in August by 72 basis points to 1.54%.
Expected performance in such an environment
Traditionally, active fundamental credit managers tend to outperform in periods of falling spreads and to underperform in periods of rising spreads. We have shown recently that this pattern is widespread among fundamentally managed credit portfolios. The following graph is from the publication above and shows the relationship between market spread changes and fundamentally managed credit portfolios.
Figure 2: Market spread changes and fundamentally managed Euro IG credit fund alphas
Figure 2 shows the relationship between monthly fund alphas of a systematic quant strategy as well as various groups of fundamentally managed funds on the one hand and the market spread change on the other hand. Details of the fundamental peer group and the methodology can be found in the paper. As can be seen from the figure, fundamental fund alphas, on average strongly depend on the market direction with outperformance usually occurring in periods of spread rallies while underperformance being the prevalent outcome in phases of rising credit spreads. This dependency is much less present for the systematic strategy.
“The expected pattern was just the opposite of what could be observed on the market. We try to explain which effects may have caused this very unusual performance pattern in summer 2022.”
Dr Harald Henke
Head of Research Fixed Income
Observed performance in summer 2022
Against the backdrop of these observations, one would have expected a return pattern among fundamental credit managers of an outperformance in July 2022 given the strong spread rally and an underperformance in August 2022 due to spreads closing higher at the end of the month. However, publicly available results of fundamentally managed mutual funds show a different picture as can be seen in the next figure.
Figure 3: Alpha of Euro IG credit funds in July and August 2022
As can be seen, only 39% of all Euro IG strategies outperformed in July 2022 despite credit spreads tightening at the strongest pace since the post-Covid rebound in April 2020. Likewise, performance numbers were positive for 86% of all funds in August 2022 despite a spread increase of 15 basis points from end of July. The expected pattern was just the opposite of what could be observed on the market. We try to explain which effects may have caused this very unusual performance pattern in summer 2022.
Explanation 1: Unusual performance of rating classes
An explanation may lie in the performance of the different rating classes in July and August 2022 as shown in the next graphs:
Figure 4: Euro IG performance by rating class
A very unusual pattern emerges from figure 4. As can be seen, in July – despite strongly positive returns over all rating classes, the BBB/Baa complex underperformed the overall market with BBB-/Baa3 rated bonds and the split rating bucket underperforming the market. Similarly unusual, in August – despite spread widening – the BBB/Baa complex outperformed the overall market with BBB-/Baa3 rated bonds and bonds with split rating as the best-performing assets. If an asset manager implemented a long credit beta position by overweighting BBB/Baa, and in particular BBB-/Baa3 rated issuers, the usual relationship between market spread movement and fund performance may have been overcompensated by the performance of the lower quality end of the rating spectrum.
While these performance numbers are not adjusted for duration differences, we see that the different rating buckets are relatively close to each other in terms of duration. While the BBB/Baa bucket currently has a modified duration of around 4.7, the same number is 5.0 for A. Moreover, in August, for example, index spreads widened only by 11 basis points for the BBB/Baa complex, while they increased by 18 basis points for A rated issuers on average.
“This multi-factor signal is the basis for selecting bonds in a portfolio and is an important explanatory signal for the performance of systematic strategies.”
Dr Harald Henke
Head of Fixed Income Portfolio Management
Explanation 2: Sector performance
The second explanation relates to the sector performances in Euro IG credit. Given that the summer months are usually characterised by lower liquidity, volatile swings in sector performances are probably associated with equal swings in relative fund performance as large portfolio rebalancing activity is less likely when liquidity is low. The following figures show sector performances in July and August:
Figure 5: Euro IG sector performances
The graphs show some rebound effects on a sector level. Communication, consumer staples and health care are among the four top-performing sectors in July, while they are the worst performers in August 2022. Banks and insurance companies underperformed in July while they were the strongest performers in August. A sector-based explanation, however, would mean that the majority of asset managers would have been positioned accordingly in these sectors which seems unlikely.
Explanation 3: Factor effects
Systematic credit strategies focus on the implementation of portfolios that have exposure to systematic factors. Frequently, the relevant signal is a mix of various individual factors. This so-called multi-factor signal is the basis for selecting bonds in a portfolio and is an important explanatory signal for the performance of systematic strategies. For more details about factor investing, see our factor investing paper. The following graph shows the performance of Quoniam’s multi-factor signal for the last two months.
Figure 6: Multi-factor performance
The bar chart shows the monthly relative performance of a factor portfolio consisting of the 20% of bonds with the highest multi-factor signal. These returns show the theoretical factor performance although practical results are not perfectly correlated with them due to transaction costs and liquidity. Factor effects have been considerably negative in July indicating that a mix of different factors didn’t outperform the overall benchmark in July and explaining the negative performance of the systematic strategy in that month. In August, factors showed a rebound corresponding to the positive performance of the factor strategy. However, as shown in the study mentioned above, fundamental funds tend to have a low exposure to a broad mix of systematic credit factors.
Explanation 4: Duration bets
As can be seen in Figure 1, the summer of 2022 was characterised by positive correlation between credit spread changes and interest rate changes. That led to a situation in which the performance of a portfolio with long credit and short interest rate risk was potentially dominated by the duration position of the portfolio. Therefore, the usual spread dependency of many portfolios may have been obfuscated by the large rate movements.
While we cannot say for any specific portfolio what drove performance in summer of 2022, we offer different explanations of the very unusual alpha patterns of credit funds. Investors can do their own investigation of their portfolios and those of their asset managers to determine the cause of the observed performance. With unprecedented interest volatility, worries about the future path of the business cycle and geopolitical tensions at multi-decade highs, it is important to understand the effects impacting performance.