What a difference a month makes. In September, the conversation in fixed income revolved around the long awaited September 18th Federal Open Market Committee meeting, as the market priced in the Fed's first "taper," or a decrease in the level of assets purchased by the Federal Reserve to lower market interest rates and stimulate economic growth. Given the negative impact, even the first hint at the withdrawal of monetary accommodation had on global markets in the summer, one would assume that the market would quickly shift its focus to the late October Fed meeting after the Fed failed to taper in September. The government shutdown and associated fiscal drag and the debt ceiling standoff grabbed the headlines instead. All of a sudden fiscal policy had bumped monetary policy from the main stage. Interest rates headed lower and credit spreads firmed as investors, buoyed by a delayed withdrawal of monetary stimulus, went back to the trades that had worked so well the last four years. The broad equity market gauge hit new all-time nominal highs as well. In this evolving market environment, this series is meant to give Seeking Alpha readers tips on how to tactically position their portfolio in the short-run as we digest economic data points and the machinations of the central bank.
We are now eleven 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 (delayed though it has been.) 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 eleventh edition in the series, and will examine October returns and implications for November 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. Even as yields have bounced off of their local highs given the temporary "taper" delay, fixed income returns continue to be highly variable as the end of quantitative easing draws near. I hope this series provides Seeking Alpha readers with a thoughtful discussion about how to tactically position their bond portfolio in this market environment in the short run, and provides thoughtful tools to drive alpha in the long run.
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.
October returns were positive for various fixed income classes as interest rates declined after the Fed's policy inaction in September, and the likelihood that tapering will be delayed into early 2014. The market had become very responsive to the monthly release on non-farm payrolls data as the Fed had tied its removal of support to the performance of the labor market. The government shutdown gave us a new quirk - no payrolls data as the Bureau of Labor and Statistics was shut. A Fed that had preached data dependency had limited data to form their analysis, and the status quo of easy monetary policy looked ever more likely. The debt ceiling standoff was delayed until early 2014, and it seems likely that the Fed will continue to offer monetary support as a counterbalance to the potential for a fiscal policy error. Treasuries had produced negative total returns from May to August, but have now produced positive returns for the last two months. 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.
Last month's article described the tremendous alpha that this strategy has generated historically relative to a leading high yield bond fund, with the momentum strategy producing average annual returns 2.65% higher over the trailing ten years with meaningfully lower variability of returns. This month, I thought it would be informative to show a simple graph of this strategy relative to the S&P 500 (NYSEARCA:SPY), which hit a new all-time nominal high last month.
Over the trailing thirty years, since roughly the beginning of the junk bond market, a momentum strategy that toggled between high yield bonds and Treasuries based on trailing one month outperformance produced a higher cumulative return than the S&P 500 with less than half of the return variability. Critics will point out that this has been an extraordinary period for fixed income assets, and that a normalizing interest rate environment will reduce absolute returns of this strategy prospectively. I agree, but this result has been extraordinary, and this article series will discuss the merits of this trade every month. I would still expect that this trade will produce alpha relative to the S&P 500 when adjusting for its much lower variability of returns. Next month's article will demonstrate how successful this strategy has been at positioning in the outperforming leg of the trade.
The momentum strategy suggested holding high yield bonds in October given their relative outperformance in September versus Treasuries, and followers of this trade were well rewarded as high yield bonds produced a 2.51% return. This momentum strategy suggests that holding high yield bonds in November will generate continued outperformance.
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 2013 generally) 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 as measured by the standard deviation of monthly returns (see chart above). 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.
This momentum trade would have suggested owning high yield bonds in October given their relative outperformance in September (0.99% HY and 0.69% IG). Followers of this strategy were well rewarded as high yields returns for October (2.51%) outpaced returns to investment grade bonds (1.48%). This would suggest that subscribers to this strategy continue to hold high yield bonds in November.
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 through September, and generating a total return of 14.5% over the trailing twelve months. The momentum trade has kept investors in the riskier CCC-rated bonds as rallying credit spreads have boosted these securities while rising interest rates have more negatively impacted their longer duration and higher rated cohorts. This trend of outperformance ended in October as BBs (+2.57) bested CCCs (+2.21%) for the first time in 2013.
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. Said differently, the incremental default risk of the lowest rated cohorts, which manifests itself in weak economic environments, more than offsets the higher average coupon on lower rated bonds on average over time.
Despite the long-run higher average total returns by BB-rated bonds demonstrated in the table above, CCC-rated bonds had outperformed their higher rated BB-rated cohort for ten consecutive months before modestly underperforming in October as BBs benefited from rallying Treasury yields given their longer duration relative to CCCs.
Seeking Alpha readers following this strategy should position their portfolio in bond and bond funds with lower levels of credit risk in November as the most speculative portion of the high-yield bond modestly underperformed in October. The ten consecutive months of outperformance by CCCs narrowly missed the all-time record of eleven months experienced after markets bottomed in March 2009.
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 0.04% 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. Given the outperformance of the intermediate part of the curve in September, momentum suggested that long Treasuries would underperform in October. Long Treasuries actually rallied more in October, which would suggest owning higher levels of duration in November.
It was a rare easy month to generate returns in fixed income in October as both Treasury yields and credit spreads rallied as the market priced in an extended period of quantitative easing. Given this highly variable fixed income markets in 2013, investors should know not to get too comfortable and remain tactical with their fixed income allocation. This momentum series will continue to offer a monthly discussion of key fixed income markets. Also look for my updates to my monthly series on momentum in the stock markets and between the stock and bond markets. Thanks for reading.