Improving Investment Grade Bond Returns With Momentum

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 |  Includes: GOVT, LQD
by: Ploutos

With yields on fixed income securities near record lows, I recently wrote about a momentum strategy utilizing high yield bonds and Treasury bonds that has historically produced meaningful alpha. From July 1983 through the current period, a momentum strategy that switched between high yields bonds and Treasury bonds, based on which asset class had the best returns in the last month, produced 173 basis points of annualized outperformance versus the high yield index with only three-quarters of the volatility.

In the comments of that article, SA Editor Jonathan Liss queried whether this momentum strategy would have also produced excess returns using an investment grade index instead of high yield bonds as a component of the switching strategy. Since investors have unique risk tolerances, perhaps some Seeking Alpha readers would prefer a strategy that eschews speculative grade-rated bonds.

A switching strategy utilizing the most commonly referenced investment grade bond index, the Barclays Capital U.S. Investment Grade Index, and the Barclays Capital U.S. Treasury Index produces a modicum of alpha. From mid-1983 through the end of July 2012, the momentum strategy produced 17 basis points of annualized return in excess of the investment grade index while exhibiting variability more closely resembling Treasury bonds than investment grade corporate bonds. This strategy can be easily implemented by investors through the iShares ETFs LQD and GOVT, which replicate the aforementioned corporate and Treasury index respectively.

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When I wrote the article about the momentum strategy utilizing the high yield bond index and the Treasury index, I originally used the investment grade index in conjunction with these two indices as part of a three-asset switching portfolio when researching the data. Including the investment grade index with the high yield and Treasury components had little effect on the performance of the strategy as the high yield and Treasury choices dominated depending on the directionality of credit returns. In the Treasury/IG strategy, when the strategy dictates a credit investment, you would typically prefer going further down in quality to high yield rather than in investment grade and earn the additional return. While the high yield and Treasury indices had little correlation (r=0.05), the investment grade index and the Treasury index had a very strong correlation, with a correlation coefficient of 0.76.

Momentum strategies have been proven to generate excess returns across a host of investment markets, geographies, and time periods. The 17 basis point annualized excess return and reduced volatility of this strategy is still meaningful (the average credit spread on the investment grade index is currently 156 basis points). However, momentum strategies, like my earlier article on investment grade bonds and emerging market stocks, work best when the investment choice set has limited or even negative correlation.

Historical Data

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