We are now twelve months into my monthly series on momentum strategies. In addition to the four strategies I post each month on fixed income, I have also been posting three stock/bond momentum strategies, and two momentum strategies within various equity classes. Each month, I have tried to add new insight into these various trades, typically at the request of reader feedback from the prior month. The added content has extended the length of the articles. Consistent with the article Seeking Alpha CEO David Jackson posted on how users read on the web, I will be breaking these three articles up into their individual strategies, and will focus on adding content in readily consumable graph and table form rather than my typical expansive narrative form.
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.)
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.
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 like we have seen in 2013, speculative grade credit spreads improve while Treasury bonds often weaken due to the expectation of 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 (approximated through JNK) based on which index had outperformed in the trailing month, and holding the outperforming index forward for an additional one month. Because high yield bonds outperformed in October versus Treasuries (2.51% HY; 0.48% Treasuries), the strategy owned high yield bonds in November when tightening credit spreads on high yield bonds produced positive returns despite the rate selloff that saw Treasuries produce negative returns for the month. This strategy would continue to own high yield bonds in December.
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 (SPY) 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.
Skeptics will again point out that the high yield/Treasury momentum trade lagged the S&P 500 pre-crisis. The strength of the momentum trade is missing large drawdowns. When equity markets and speculative grade bonds are falling in value in recessionary environments, they continue to fall in value, and this momentum trade would swap to the outperforming Treasury leg. This is evidenced by the table below that shows that even when the momentum strategy was producing its largest drawdowns, the pullback was quite minor. Over the momentum strategy's worst two year period, it produced a positive total return (+2.21%).
Another way to demonstrate the consistency of the momentum strategy is to examine annual total returns. The momentum strategy only produced one negative total return in the past thirty years, and that was during the great interest rate selloff of 1994, the only year that both Treasuries and high yield bonds both produced negative total returns.
(click to enlarge)
Rotating between high yield bonds and Treasuries based on trailing outperformance has produced long-run alpha, and Seeking Alpha readers should understand this phenomenon when positioning their portfolios. The data displayed in this article is index data, and the performance of exchange traded funds replicating the high yield bond component of this strategy will deviate from the performance of the underlying index, especially in periods of low liquidity, but the premise underpinning this strategy remains sound and demands investigation. The momentum strategy suggested holding high yield bonds in November given their relative outperformance in October versus Treasuries, and followers of this trade were rewarded as high yield bonds produced a positive total return in a weak month for fixed income. This momentum strategy suggests that holding high yield bonds in December will generate continued outperformance.