How did credit factors perform in 2023?

Spread movement 2023

2023 was a volatile year for credit spreads with a conciliatory end. Euro IG spreads started the year at a level of 1.67% and ended almost 30 basis points lower at 1.38%. Global corporate IG spreads started the year at 1.47% and closed at 1.15%. Overall, therefore, credit returns were clearly positive.

However, the following chart shows that in some cases things looked different in 2023. It shows the evolution of euro-denominated and global credit spreads that moved between one and two percent in 2023.

After starting 2023 with a spread rally, the crisis at US regional banks and the forced takeover of Credit Suisse in March led to a mini banking crisis and the highest spread level of the year. From there, spreads tended to fall, but were repeatedly interrupted by short, sharp spread increases such as at the end of April/beginning of May and in October. It was not until the year-end rally in November and December that bond yields not only turned positive, but credit spreads also fell to their lowest level of the year.

Factor returns 2023 and historical context

How have systematic credit factors performed in this environment? We look at carry (investing in high spreads), momentum (investing in bonds of companies whose shares have recently outperformed), value (bonds that are undervalued relative to their fair value), quality (bonds of issuers with above-average balance sheet quality) and the multi-factor signal, which is a combination of the individual signals.

The analysis is based on portfolios that have no restrictions such as transaction costs, illiquidity or restrictions on deviation from the benchmark. With the exception of the carry factor, whose values can vary widely between bonds of different maturities issued by the same company, we use a synthetic five-year bond per issuer to avoid large differences in interest rate or spread duration between the factors. The resulting portfolios show differences in their credit risk as measured by DTS. However, this is part of the factor characteristics, as carry, for example, is riskier than momentum or quality.

Each month, at the end of the last trading day, the portfolio invests equally weighted in the top 20% of the respective signal to benchmark spread and then keeps the portfolio holdings constant for one month. Factor performance should therefore not be taken as an indicator of performance potential, as frictions and costs inevitably lead to deviations in live-portfolio returns. However, a comparison between the years and strategies helps to draw conclusions about factor performance in 2023. The multi-factor signal corresponds to the Quoniam definition.

Figure 2 shows the annual performance 2023 of the above-mentioned credit factors for the Euro IG and Global IG credit factors.

As can be seen from the chart, since the rally at the beginning of the year, carry has outperformed the other factors, outperforming both Euro IG and Global IG Credit by almost 3%. Value and the combined multi-factor signal also achieved positive outperformance with values slightly above (Euro IG) and slightly below (Global IG) 1%.

While the momentum factor only achieved a performance roughly in line with the market performance, quality lagged significantly behind the market performance across all strategies and was the weakest factor in 2023.

To categorise this factor performance, Table 1 compares the performance of 2023 with the average performance of the previous 5 years 2018 – 2022¹.

The significantly better performance of carry due to the favourable spread environment in 2023 is striking, while the years 2018 – 2022 were characterised by two major slumps around the start of the coronavirus pandemic in March 2020 and the spread increase in 2022 and subsequent recoveries. As a result, the factor had an average neutral performance for Euro IG and a slightly positive performance for Global IG over the previous five years. This was clearly exceeded in 2023.

Value is above the five-year average in both strategies, while quality was at least able to improve on the weak five-year average in Global IG Credit. Momentum was unable to fulfil the promise of previous years in the volatile environment of 2023 with several sharp up and down phases on the markets.

The multifactor signal clearly outperformed the average of previous years, at least in Euro IG Credit, with an outperformance of 1.14%, while it lagged slightly behind the average in Global IG. However, this represents a significant increase compared to the signal’s weak performance in 2022.

Outlook: 2024 and beyond

No one can say with certainty what the next few years will bring in terms of factor performance. However, looking at the current political and economic environment, there are good arguments in favour of factors being successful in the near future. This environment has changed massively in recent quarters, which has lasting implications for investment decisions.

The last 15 years have been a period of easy monetary policy. Starting with the TARP programmes, in which hundreds of billions of dollars were spent to rescue the banking system, through interest rate cuts to zero in the US and below zero in Europe and Japan, to massive bond-buying programmes (“quantitative easing”), cheap money has fuelled capital markets and led to above-average returns on risk assets.

Asset prices rose and interest rates fell steadily, and when a crisis such as the coronavirus pandemic shook the market, the central bank put kicked in and central bankers ensured that investors’ portfolios were hedged. This perceived protection against downside risk, combined with extremely favourable funding conditions, meant that some investors continued to leverage their returns in this environment.

Times have changed forever. In the face of high inflation rates, monetary policy is a brake on capital market growth, as we have seen from the sharply negative returns in 2022. High interest rates and a sharp increase in interest rate volatility, the active unwinding of central bank balance sheets and the end of monetary policy support are likely to ensure that the successful strategies of the cheap money era will have to be reconsidered and adapted.

In particular, this means that strategies that have historically been overweight risk are likely to perform less successfully than in the recent past. Risk management, diversification of risks and styles and avoiding downgrades will become more important. Active management of interest rates and liquidity in the absence of the central bank as an unconditional buyer of bonds is an additional challenge.

In such an environment, where market forces are back in play and political influence is waning, factor strategies can once again play to their strengths. The year 2023 offered a first taste of the new investment world. 2024 will show whether the trend continues. We look forward with excitement and confidence.