Seeking Alpha

Simple High Yield/Municipal Bond Tactical Strategy For A Rising Rate Economy

by: Cliff Smith

This strategy is a tactical bond strategy based on low duration moving averages. The strategy has the potential for moderate growth (~11-12%) with low maximum drawdown (~4%).

Two ETFs are utilized in the strategy (HYLD and HYMB) that have the potential to perform well in a rising rate environment.

Each ETF is assessed using low duration moving averages. A cash safety net is used if both ETFs are in the risk-off mode.

If both ETFs are in the risk-on mode, a final analysis is performed to determine the best ETF. Alternatively, one can invest 50/50 between the two ETFs.

Backtest results using ETFreplay show the overall potential of the methodology.

A rising rate market environment is soon to be upon us, and there is a need to maintain moderate growth in our portfolio without excessive downside risk in such an economy. For the past few decades, treasuries have been the safe haven for investors who desire moderate growth and low risk, but that might be changing as rates rise and value correspondingly drops. Buy-and-hold treasury strategies will probably produce poor performance over the next few years.

I believe tactical bond strategies are the better option. Over the past year, I have developed a number of bond strategies that should produce moderate annual growth and low maximum drawdowns. One such strategy is the popular Simple Bond Strategy, SBS, that invests either in AdvisorShares Peritus High Yield Bond ETF (NYSEARCA:HYLD) or Barclays Low Duration Treasury Bond ETF (NASDAQ:SHY) based on the crossover of 25-day and 3-day simple moving average ratios (HYLD/SHY). You can find information on this strategy here.

This strategy has been backtested to 2000 using a mutual fund proxy (Vanguard High Yield Bond Mutual Fund - VWEHX). The backtest results have shown a Compounded Annual Growth Rate, CAGR, of 12.5% with positive growth in every calendar year and 3.5% maximum drawdown. Through bull market conditions and bear market conditions, this tactical strategy has produced good performance from 2000-present.

I have been tracking the SBS in real time since early in 2014 (see my Instablog articles). The strategy has worked quite well so far, and we are currently in a risk-off mode for HYLD. YTD total returns are 5.4% for SBS, while YTD returns are only 1.8% for HYLD. Because I sent out advance warnings that crossover days were eminent, many investors have actually seen even better real returns in 2014 YTD, some as high as 6.0-6.5%.

I think the reason this strategy works is because of the low volatility of the ETF. Low duration moving average strategies can successfully get you out of a low volatility ETF early in a downturn, and get you back into the ETF early is an upturn. For low volatility ETFs, whipsaw does not seem to be as much of an issue with SBS as it is with higher volatility ETFs.

I wanted to enhance the Simple Bond Strategy of HYLD/SHY in a rising rate environment. Two bond asset classes that should be able to do well in a bull equity economy with rising rates are: 1) high yield bonds (like HYLD) and 2) municipal bonds. This was part of the conclusion in a recent Wall Street Journal article. In this article, both high yield bond ETFs and municipal bond ETFs are recommended when Fed rates are increasing.

Thus, I have decided to include the municipal bond class in an enhanced version of the SBS. The municipal bond ETF I have chosen is SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEARCA:HYMB). So the SBS will now include both the HYLD/SHY sub-strategy and a HYMB/SHY sub-strategy. Both sub-strategies will use low duration moving average methods.

In a rising rate environment, it will be beneficial to modify the basic HYLD/SHY strategy to HYLD/Cash and likewise the HYMB/SHY strategy to HYMB/Cash. I believe the safety net needs to be cash rather than SHY in these times. When short-term rates increase, the value of SHY will decrease. So it is better to have our money in cash rather than SHY.

Here is how the combined HYLD/Cash - HYMB/Cash Simple Bond Strategy works. Both HYLD and HYMB are analyzed using 25-day and 3-day simple moving averages. If the 3-day moving average is above the 25-day moving average for one of the two ETFs, we invest totally in that ETF. If the 3-day moving average is below the 25-day moving average in both ETFs, we hold our money in cash. If the 3-day moving average is above the 25-day moving average in both ETFs, we have two options: 1) put 50% of the portfolio money into each one (i.e. 50% in HYLD and 50% in HYMB), or 2) proceed to a final analysis that selects the best ETF between HYLD and HYMB.

This final analysis calculates the HYLD/HYMB ratio and looks at the 5-day moving average ratio and the 15-day moving average ratio. If the 5-day moving average ratio is greater than the 15-day moving average ratio, HYLD is selected. Otherwise, HYMB is selected.

The ETFreplay results from June, 2011-to-present for the HYLD/Cash part of the strategy are shown below. The overall total return is 34.3% (CAGR ~ 9.5%) with a maximum drawdown of -3.6%. There are 13 trades over this span, an average of about four trades per year. Please note there have been a number of downturns of HYLD in this time period (even today as this is being written), and the HYLD/Cash sub-strategy has gotten out of HYLD early in the downturns and back into HYLD early in the upturns. At the present time, we are in the risk-off mode for HYLD.

The ETFreplay results for the HYMB-Cash part of the strategy are shown below. The overall total return is 43.3% (CAGR ~ 11.5%) with a maximum drawdown of -4.1%. There are twelve trades overall, about four trades per year. At the present time, we are in the risk-on mode for HYMB.

The ETFreplay results of the HYLD-HYMB sub-strategy are shown below. This is the final analysis to be performed if both HYLD and HYMB are both in risk-on status based on the HYLD-Cash and HYMB-Cash sub-strategies. This final analysis is used to determine which ETF is selected if only one ETF is to be chosen. The other option is to put 50% in HYLD and 50% in HYMB if both are in risk-on status.

The overall total return is 52.6% (CAGR ~ 13.5%) with a maximum drawdown of -5.8%. Please note that these are the results only if both ETFs were in the risk-on mode all the time (from June, 2011 - present). Of course, that did not actually happen in this time period.

In conclusion, this Enhanced Simple Bond Strategy, ESBS, shows good potential to produce moderate growth (CAGR ~ 11-12%) with minimal drawdown (~-4%) in a rising rate environment. Although ESBS has a limited backtest period, the basic low duration moving average methodology (utilized here) has been shown to be successful for low volatility bond ETFs like HYLD and HYMB in previous articles. Indeed, the low duration moving average approach was successfully backtested on the HYLD proxy VWEHX all the way back to 2000.

Disclosure: The author is long HYMB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.