It has been a fascinating year for fixed income as we have potentially reached an inflection point where post-crisis lows in interest rates driven by extraordinary monetary accommodation are finally giving way to normalization. In this changing market environment, this series is meant to give Seeking Alpha readers tip on how to tactically position their portfolio in the short-run.
We are now nine 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, the momentum strategies have continued to demonstrate how they have generated long-run alpha, tactically positioning in less rate-sensitive credit classes. 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 ninth edition in the series, and will examine August returns and implications for September 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.
August returns were negative for various fixed income classes as interest rates increased and credit spreads widened moderately. Treasuries have now produced negative total returns for the fourth straight month, a streak that had not been previously realized since the end of 2010 and the start of 2011. Treasuries have produced four months of negative total returns on only six occasions since 1973. While rising interest rates produce negative total returns for current bondholders, they also enable higher yields on future bond purchases due to the inverse nature of bond prices and yields, and this article will discuss where short-term opportunities in fixed income may exist.
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 high yield bonds in August given their relative outperformance in July versus Treasuries (+1.9% vs. -0.11%). Treasuries modestly underperformed high yield in August (by 12bps), suggesting that investors own Treasuries in September over high yield bonds. In last month's version of this article, I detailed a trade between long Treasury bonds (replicated by TLT) and high yield bonds, a momentum strategy that has also produced long-run alpha. For investors using the longer duration Treasury index (TLT) instead of the entirety of the Treasury curve for the high quality leg of this momentum trade, high yield bonds should be held in September given their modest outperformance relative to long duration Treasuries in August.
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. Over the last three years, investors who employed this particular momentum strategy would have nearly doubled the average annual return of holding investment grade bonds with roughly the same 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 August, investment grade bonds (-0.7%) modestly underperformed high yield bonds (-.61%). This August return profile suggests that high yield bonds will outperform investment grade bonds in September.
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 of 7.8% so far this year.
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 nine 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%. In August, credit spreads modestly widened, but the higher carry of CCCs still led to relative outperformance.
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. The nine consecutive months of outperformance by CCCs is nearing the all-time record of eleven months experienced after markets bottomed in March 2009. Momentum investors should continue to overweight the most speculative grade cohort, but spread compression between CCCs and BB's may be reaching a point where relative value is greater in the higher quality rating cohort.
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.
This strategy is meant to demonstrate the efficacy of using relative trailing returns to help fixed income investors position on the yield curve. 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 0.02% 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). Given the sharp rate sell-off this summer, momentum that suggested holding the intermediate portion of the curve relatively outperformed again in August. 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 sell-off momentum investors wanted to continue to position on the short end of the curve, or short the long end of the Treasury curve. Long Treasuries again underperformed intermediate Treasuries in August, albeit by a decreasing amount. Fixed income investors should continue to favor shorter duration securities in September.
August's returns would signal that fixed income investors would want to continue to avoid long duration asset classes in September, favoring asset classes with higher credit spreads and shorter durations. Investors will continue to look towards the Federal Open Market Committee meeting on September 17-18, with the long-awaited decision on whether to taper quantitative easing likely driving fixed income performance. 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.