Dual Momentum Fixed Income

by: Gary Antonacci

Momentum is most commonly applied to stocks. But it works just as well, if not better, when applied to bonds. Our Dual Momentum Fixed Income model switches monthly between the strongest one of the following indexes: Barclays Capital U.S. Credit Bonds, Barclays Capital U.S. Corporate Hi Yield Bonds, and 90-day U.S. Treasury bills.

The reason for choosing credit bonds instead of Treasury bonds for the core of our model is because of modern portfolio theory principles. There is a risk premium associated with credit bonds that is absent from U.S. Treasury obligations, which have only duration risk. Since an indexed credit bond portfolio holds hundreds of different bonds, nearly all the idiosyncratic risk associated with credit bonds has been diversified away, leaving a premium that can be captured with little practical credit risk.

One can also argue that applying absolute momentum (by selecting Treasury bills when their returns are higher than bonds) to a credit bond portfolio reduces portfolio stress, which further eliminates systematic risk. There is little reason, then, to hold Treasury bonds, since they provide a lower total return without a significant reduction in portfolio risk.

Here are the Dual Momentum Fixed Income (DMFI) results from applying our model to the following bond indexes. The high-yield bond index began in July 1983, so results are from January 1984 through November 2014:

Annual Return 9.78 8.58 4.07 11.08
Annual Std. Dev. 8.54 5.48 0.80 5.15
Annual Sharpe 0.73 0.94 1.09 1.44
Max Drawdown -33.31 -7.25 0 -5.89
% of DMFI Profits 59 32 9 *
% of Occurrences 35 28 12 *
Avg. Credit Rating B BBB AAA *
Avg. Duration (Yrs.) 4.5 7.1 0.3 *

Historical data and analysis should not be taken as an indication or guarantee of any future performance.

What is especially interesting is that DMFI returns are more than 100 basis points higher than the returns of high-yield bonds, while DFMI volatility and maximum drawdown are lower than those of investment-grade credit bonds. With average years to maturity of 4.5 and 7.1 for the high yield and credit bond indexes respectfully, dual momentum achieves these impressive results without having to assume a lot of duration risk. Instead, DMFI navigates effectively along a relatively short area of both the yield and quality curves, while simultaneously avoiding the drawdowns that accompany high-yield bonds. The monthly and yearly returns from DMFI are on the Performance page of our website, where they will be updated each month.

Given the level of current interest rates and the strong bull market in bonds we have had over the past 30 years, if you think there will be comparable bond market results over the next 30 years, then I have a very nice bridge to sell you. But given more modest expectations from the fixed income markets, dual momentum looks like it can offer superior returns to individual intermediate-term fixed income bonds for those who require some exposure to the fixed income markets. More importantly, given the potential risks of higher future interest rates, a dual momentum approach may offer some welcome insulation from the pernicious effects of rising rates on one's fixed income portfolio.

Disclosure: Please see our website Performance and Disclaimer pages for additional disclosures.