We are now eight months into my monthly series on fixed income momentum strategies. While Treasury and investment grade corporate bonds have produced negative total returns year-to-date, all three of my credit-based momentum strategies have produced positive total returns. Negative total returns in high quality fixed income have been produced by the move higher in interest rates, driven by the pull forward of market expectations around the ultimate terminus of quantitative easing. While less rate-sensitive asset classes, like speculative grade high yield bonds, have outperformed on a relative basis, the swoon in high yield bonds in June was the worst monthly performance for speculative grade credit since the U.S. credit rating downgrade in August 2011. In spite of these rocky returns for the individual asset classes, these strategies have continued to prove their worth, which is readily demonstrable in the long-run studies of these strategies detailed in the article.
In this series, 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 eighth edition in the series, and will examine July returns and implications for August 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 and have headed sharply higher over the past several months. 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 tolerance 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. July served as a bounce back for fixed income markets. While Treasuries continued to weaken due to higher interest rates, high yield bonds turned in their best monthly performance thus far this year as fund flows reversed, sending credit spreads tighter. Investment grade corporate bonds saw enough spread tightening to offset the move in rates, producing a return of 0.8% for the month. 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.
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.
The momentum strategy suggested holding Treasuries in July given their relative outperformance in June (-1.1% for Treasuries and -2.6% for high yield bonds), and underperformed in July as high yield bonds rallied. June was a particularly unique month in the fixed income markets. The broad high yield and Treasury bond markets each produced returns of less than one percent, the first time that feat had occurred in both asset classes in ten years, bucking the traditional trend of negative correlation between credit spreads and Treasury yields.
Interestingly a momentum strategy between long Treasury bonds and high yield would have correctly held high yield bonds in July and benefited from the bounce back. Readers have frequently commented that they would like to see a momentum strategy between Long Treasuries (replicated through the ETF TLT) and high yield bonds. Earlier this week, I answered these readers' request in an article entitled: "High Yield/Long Treasuries." In the seven previous versions of this article, I have detailed a version of the high yield/Treasury switching strategy that uses the entire Treasury yield curve as one of the legs. The long-run return profile of an alternative momentum switching strategy involving long duration Treasuries, defined as those with greater than twenty year to maturity, and high yield bonds instead of the Treasuries is detailed below:
Readers employing either momentum strategy would favor high yield bonds over Treasuries in August. For readers interested in seeing a monthly update to this version of the Treasury/High Yield momentum strategy, please respond in the comments section of this article.
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 the past several months) 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 June with investment grade bonds (-2.76%) modestly underperformed high yield bonds (-2.62%). 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 suggested that high yield bonds would outperform investment grade bonds in July, which is what happened as lower quality bonds outperformed. This momentum trade would suggest that high yield continues to outperform more rate sensitive investment grade bonds in August as well.
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. This trade has been the stalwart of my fixed income momentum series in 2013, correctly predicting the outperforming leg in each month, and generating a total return exceeding eight percent of the year thus far.
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 eight consecutive months. despite producing their worst monthly total return since late 2011. While credit spreads widened across asset classes in June, the outperformance of CCCs signaled that this spread widening was driven by higher rates and the need to meet redemptions and not credit concerns, or CCCs would have likely underperformed. As markets bounced back in July, CCCs still led the way, producing a monthly total return of 2.69%.
Seeking Alpha readers following this strategy should position themselves in bonds and bonds funds with higher levels of credit risk in August 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 0.03% 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). Given the sharp rate selloff in May and June, momentum that suggested holding the intermediate portion of the curve relatively outperformed again in July. Investors who chose to continue to short long Treasuries (like through inverse long duration ETF TBT after May's horrendous return were well rewarded in June and July, especially against the specter of weak asset returns in most global asset classes. Given July's selloff momentum investors would want to continue to position on the short end of the curve, or short the long end of the Treasury curve.
July's returns would signal that fixed income investors would want to continue to avoid long duration asset classes in August, 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.