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My most recent article highlighted the long-term advantages of BB-rated bonds relative to lower-rated B and CCC-rated bonds. Double-BB rated bonds have had higher average returns over a long-time horizon while exhibiting lower volatility of returns. However, given the pro-cyclicality of speculative-grade bond returns, when an economy and its credit markets are recovering the lowest rated bonds do outperform in the short-run. This article examines whether there is a way to time the tradeoff of moving down in credit quality to earn increasing returns, but being able to exit the trade before default rates on these lower rated credits increase.

Followers of my earlier articles know that I have taken a keen interest in momentum strategies that can enable investors to earn higher risk-adjusted returns over time. Below is the performance of a strategy that buys the speculative grade ratings cohort that produced the best returns in the trailing one month and holds that basket for the next one month. Total returns are from the Barclays U.S. Corporate High Yield Index for the trailing 20 years.

The average return of the momentum strategy outperforms each of the different ratings cohorts. The variability of returns illustrates that this is a strategy with a risk profile between that of a single-B and triple-CCC rated portfolio. Of the 240 months in the sample period, nearly half of the time (114 occasions) the momentum strategy would invest in CCCs, including ten consecutive months from March 2009 to January 2010 as markets recovered.

While there currently is not a readily available fund that invests in a ratings specific fashion that would allow retail investors to replicate this momentum strategy easily, understanding the momentum strategy has important implications for maximizing risk adjusted returns. If trailing high yield returns for the previous one-month favor funds that have a higher risk profile and higher weights down the quality spectrum, then these higher beta funds should outperform relatively over the next one-month. If funds consisting of higher quality bonds are outperforming, then a relative flight-to-quality trade is likely to persist for the next one month. The significance of the momentum factor dissipates decidedly in a three month look back/three month forward holding period trade. Given the significance of the outperformance of the momentum strategy (the 400 bp outperformance of momentum relative to BBs is 85% of the total credit spread offered in BBs currently), contemplation of what momentum tells us about our relative investment allocation in the short-run should be used to complement your tactical allocation in high yield bonds.

While double-BB bonds are still your best long-term best from a risk-adjusted return standpoint, a strategy that rotates out of double-BB bond ETFs (NYSEARCA:HYG), PHB or a double-BB focused closed end fund like NHS and moves down the quality spectrum into funds that prominently feature CCC-rated investments, such as, HIX, DHG, or PHT when the high yield bond market is performing well could improve short-run performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Momentum And High Yield Bonds