Fixed Income Momentum - July 2013

Jul. 3.13 | About: SPDR Barclays (JNK)

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 seventh edition in the series, and will examine June returns and implications for July 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 as yields have rebounded from historical lows. As fixed income returns become more variable upon the end of quantitative easing, I hope this series provides Seeking Alpha readers with a thoughtful discussion about how to tactically position their bond portfolio.

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.

Returns in June were weak across fixed income markets as longer duration fixed income instruments underperformed. Credit spreads also leaked wider as redemptions of bond funds forced additional sellers on the market. This article will interpret these results and detail how readers may want to position their portfolio over the next one month.

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. While Treasury yields and high yield credit spreads are typically negatively correlated, both markets sold off in June as Treasury yields increased and credit spreads on speculative grade credit widened. Both the Barclays Treasury Index (NYSEARCA:GOVT) and the Barclays U.S. High Yield Index (NYSEARCA:JNK) produced returns that were worse than -1% in the same month for the first time in eight years.

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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 previous eleven months, the momentum strategy had 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. This trend did not hold in June as high yield bonds underperformed. Momentum would suggest that high yield spreads continue to come under pressure in July, causing high yield bonds to lag Treasuries.

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.

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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 and June) 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.

In May, both investment grade and speculative grade bonds produced negative total returns, but the longer duration investment grade index caused that sector to be the laggard as rates sold off. This trend continued in June with investment grade bonds modestly underperforming high yield bonds. Both investment grade bonds and speculative grade bonds had not both produced monthly returns of less than -2.5% since the disastrous post-Lehman October 2008. This June return profile suggests that high yield bonds will outperform investment grade bonds in July.

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.

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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 seven 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. This outperformance would have kept investors in CCC's in June where they modestly outperformed the more rate sensitive BB's again despite producing their worst monthly total return since late 2011. While credit spreads widened across asset classes in June, the outperformance of CCC's signals that this spread widening was driven by higher rates and the need to meet redemptions and not credit concerns, or CCC's would have likely underperformed.

Seeking Alpha readers following this strategy should position themselves in bonds and bonds funds with higher levels of credit risk in July 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.

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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 0.09% 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 (NYSEARCA:SPY). After this momentum trade was whipsawed by the long end's historically weak return in May, owning the intermediate part of the curve in June allowed this strategy to recapture some its performance. Momentum would suggest holding the intermediate portion of the curve again in July. Investors who chose to continue to short long Treasuries after May's horrendous return were well rewarded in June, especially against the specter of weak asset returns in most global asset classes.

Summary

June's returns would signal that fixed income investors would want to continue to avoid long duration asset classes in July, favoring asset classes with higher credit spreads and shorter durations. While these momentum strategies will see some volatility as Federal Reserve governors fine tune their communication with markets and ultimately gradually reduce the amount of monetary accommodation, the long-run strength of these strategies is undeniable, and I hope they serve as a tactical portfolio allocation tool for readers.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.