In January 2013, I began authoring a monthly series on momentum strategies within the fixed income universe. In past articles, I have highlighted momentum strategies across asset classes that have produced excess returns per risk borne, or alpha, over long-time intervals. Momentum switching strategies between 1) Treasuries and high-yield bonds; 2) investment-grade bonds and high-yield bonds; 3) between the highest quality (Ba/BB) and lowest quality speculative grade bonds (Caa/CCC); and 4) between short-duration and long-duration bonds have historically produced elevated risk-adjusted returns. This is the sixth edition in the series, and will examine May returns and implications for June portfolio positioning. I believe that this article is timely given the wide discussion about whether we have reached a market inflection point in various fixed income markets.
The purpose of this series of articles is to demonstrate the long-term success of these strategies, and give Seeking Alpha readers with differing risk tolerances tips on how to employ these strategies themselves to improve the performance of their respective fixed income portfolios. These are useful strategies for Seeking Alpha readers, especially those who allocate dollars to their investment plan on a subscription-like basis like 401(k) investors making automatic payroll deductions. These switching strategies can be used to adjust periodic allocations to capture the momentum effect and improve portfolio returns, especially in tax-deferred accounts.
In January, the leg of each trade with the highest level of credit risk outperformed, signaling that higher returns would continue in February for the higher beta portion of these trades. February produced positive, yet anemic, returns for each leg of each trade, but gave mixed signals about how fixed income investors should be positioning in March. March's outperformance by risky assets signaled that investors would want to tactically position out the credit curve in April, and were subsequently rewarded. April was an odd month for fixed income returns with Treasuries and credit spreads both rallying. This trend did not hold in May as Treasuries notably weakened with credit spreads coming under pressure as well late in the month. This article seeks to interpret May's results and offer positioning tips for June.
Tailoring Your High-Yield Allocation
Treasuries and High-Yield Corporate Bonds
The most basic momentum strategy in fixed income is between Treasury bonds and high-yield bonds. The monthly strategy switches between the two asset classes, owning the asset class that performed the best in the trailing one month.
In difficult market environments, Treasury bonds rise in value as a flight-to-quality instrument while risky assets sell off as credit spreads widen. In improving economic environments, speculative grade credits improve while Treasury bonds often weaken due to rising inflation that lowers real returns. In May, Treasury bonds sold off largely due to the fact that improving economic growth may slow the Federal Reserve's purchase of these securities and investors tried to squeeze out the exit door together. Despite the quick response to any sound byte by a Fed official over the past several weeks, momentum strategies work under the principle that markets are slow to react to new information. Below is the historical performance of this high yield corporate bond/Treasury momentum switching strategy.
The long-run alpha demonstrated in the table and chart above was achieved by the simple process of owning either the Barclays Treasury Index (replicated through GOVT) or the Barclays U.S. Corporate High Yield Index (replicated through JNK) based on which index had outperformed in the trailing month, and holding the outperforming index forward for an additional one month. In the last eleven months, the momentum strategy has correctly predicted the leg of the trade that would outperform in the next one-month period on nine occasions with one losing month and effectively one tie. Despite a reversal in performance for both Treasury yields and credit spreads from the prior month, this is a trend that held again in May as high yield bonds continued their relative outperformance versus Treasuries despite their negative absolute return due to the 60bps of excess returns on high yield bonds generated by spread tightening in speculative grade credit. This outperformance signals that high yield debt should be owned versus Treasuries again in June.
Investment Grade Corporate Bonds and High-Yield Corporate Bonds
For Seeking Alpha readers with a higher risk tolerance, momentum strategies are also available between investment grade corporate bonds and below investment grade corporate bonds. Below is the historical performance of this strategy.
Investors should be cognizant of the fact that while adding investment grade corporate bonds instead of Treasuries increases the credit risk of this trade; historically, investors would not have been compensated with incremental returns. The lower correlation coefficient between Treasuries and high-yield bonds over the sample period (r=0.05) than between investment grade bonds and high-yield bonds (r=0.53) demonstrates that the individual return profiles move together less often, creating a more efficient switching strategy. Investors who have decided to eschew Treasuries altogether given historically low rates (which was not a bad idea in May) may still be interested in an IG/HY momentum portfolio, which has still generated average returns in excess of speculative grade credit alone, but with risk more closely reminiscent of an IG portfolio. While the IG-HY momentum strategy marginally underperformed in 2012 on an absolute basis, it did produce alpha when adjusting for risk. Historically, this trade has produced returns equivalent to a high-yield fund levered by an additional 15%, but with variability of returns of only 70% of that equivalent return profile.
While credit spreads rallied more for the more speculative credits in April, rallying Treasury spreads boosted the returns on the longer duration investment grade corporate bond index to slightly above that of its high yield counterpart (IG 1.83%; HY 1.81%).
The roughly equivalent returns of the investment grade and high yield corporate bond indices sets up an interesting decision in May. For documentation of this strategy, the momentum trade owned IG bonds with the hope that a rate rally or spread widening of the lower rated cohorts would be sufficient to offset the roughly 25bp/month carry advantage of the high yield market. This lead to underperformance in May as more rate-sensitive, longer duration investment grade credit underperformed high yield bonds. The momentum effect would suggest that investors favor high yield bonds over investment grade bonds in June.
BB-Rated Corporate Bonds and CCC-Rated Corporate Bonds
For Seeking Alpha readers with an even higher risk tolerance, toggling between the highest and lowest rated cohorts of the high-yield segment of the market based on momentum has also produced alpha over long-time intervals.
While there are no specific exchange traded funds that target BB or CCC-rated bonds specifically, funds regularly publish the ratings distribution of their investments. Understanding positive momentum in high-yield bonds should help Seeking Alpha readers know when to dip down in quality to higher-yielding single-B and triple-C rated bonds. More importantly, understanding momentum will help investors miss big negative swings in performance of these risk sub-sectors when credit losses begin to eat into portfolio returns. Below is the historical performance of a momentum switching strategy between BB and CCC-rated bonds.
Historically, this momentum switching strategy would have outperformed owning high yield outright by roughly 370bps per annum. Investors should also note from my article in late January that BB-bonds tend to outperform CCC-bonds over long-time intervals due to their lower default rates, so earning alpha by going to the bottom of the credit spectrum must be done tactically.
Despite the long-run higher average total returns by BB-rated bonds demonstrated in the table above, CCC-rated bonds have now outperformed their higher rated BB-rated cohort for six consecutive months. While CCC's produced a zero total return in May, they still outperformed BB's in part due to the higher interest rate sensitivity of higher quality BB-rated credit. Seeking Alpha readers following this strategy should position themselves in bonds and bonds funds with higher levels of credit risk in June as the most speculative portion of the high yield bond market continues to outperform.
Adjusting Your Portfolio Duration
Intermediate Duration Treasuries and Long Duration Treasuries
All three of the aforementioned trades have used momentum to opportunistically time entry points to increase or decrease credit risk. The trade below demonstrates that momentum is also useful in timing bets on another key component of fixed income returns: interest rates.
While this momentum strategy has not outperformed on an absolute basis over the entirety of the 40-year sample period, the momentum switching strategy has produced alpha. The average annual return of the momentum strategy is only 0.15% lower than the long Treasury-only strategy, while exhibiting only about three-quarters of the volatility.
As I wrote recently, the long end of the Treasury curve is a tough place to invest given ultra low expected real returns and trailing volatility that mirrors that of the S&P 500 (SPY). In April, the long end of the curve led the Treasury rally as several weak economic data points, both domestically and in Europe, coupled with aggressive monetary accommodation from Japan that sparked the belief that money would rotate from long JGB's to long Treasuries saw a sharp rally for the long Treasury index. This momentum strategy, which owned intermediate Treasuries given their relative outperformance in March, missed this trade, marking the largest underperformance of this momentum strategy in nineteen months. The momentum signal that long duration bonds would outperform in May due to April's outperformance led to even greater underperformance for this strategy as the long duration index returned a brutal -6.24%.
While the strength of these momentum strategies is typically the ability to miss big down moves, the -6.24% return for long Treasuries was the second worst absolute performance for this index dating to 1973. Momentum would suggest holding the intermediate portion of the curve in June, but given how this trade has been whipsawed by changes in market perception about the duration of quantitative easing it may be losing its efficacy in communicating bond duration positioning.
While April was an interesting month for fixed income returns as both corporate credit spreads and Treasuries rallied, May was even more notable given the sharp move in Treasury yields on concerns that the Federal Reserve could begin tapering its monetary accommodation. The Treasury/HY trade has been a markedly consistent indicator of outperformance, and continues to favor below investment grade bonds. Within the below investment grade universe, CCCs are again favored for the seventh straight month, although this rating cohort's outperformance versus BBs was a function of the higher interest rate sensitivity of the higher quality BB-rated cohort in May.
These two trades traditionally signal a "risk-on" attitude for global markets, but the best portfolio positioning in May was simply avoiding long duration Treasuries and agency mortgage backed securities, the traditional flight-to-quality instrument of choice. I would continue to bias towards high yield relative to investment grade corporate bonds and Treasuries given the carry advantage and likelihood for modest further spread compression in the highest spread assets given the likelihood of continued monetary accommodation and the continuation of a low default rate environment. As we have seen, credit spreads were able to absorb a portion of the rate move we saw in May. While we were discussing record sub-5% yields in early May, the asset class is now offering more palatable yields (5.71% yield-to-worst at month-end), and will probably recapture some of the retail outflows seen at the end of the month. Monetary policy has pushed investors further out the risk curve for palatable yields, and Seeking Alpha readers can use these momentum strategies as a tool to help time a tactical shift into fixed income asset classes with lower credit risk in future periods.
As always, I appreciate reader feedback and will attempt to incorporate reader ideas into next month's edition. I am also contemporaneously authoring on momentum strategies between fixed income and equity classes, for readers examining when to allocate away from fixed income, and within various classes of equity securities. Look for June updates to these articles in the coming days.