How To Invest In Bonds Despite Rising Rates

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Includes: AGG, BND, CWB, IEF, JNK, MUB, SHY, TLT, WIP
by: Fred Piard

Summary

Rising rates make bond investing more difficult.

Tactical allocation may help keep a smarter bond exposure.

This article gives insights on an ETF strategy beating the aggregate bond index in various market regimes, from the 2008 stock crash to the post-QE period.

Keeping some bond exposure in a rising rate environment may still temper a stock portfolio’s volatility without being a heavy drag, but it needs a process to dynamically allocate the capital to the right kinds of bonds. This article gives insights on a strategy with a real track record starting in December 2013 and its performance on various time frames.

History and rationale of the model

The first version of this model was designed in 2013. At this time, I had not yet started the research on market timing indicators that resulted in the concept of systemic risk and MTS10. I just wanted a bond model outperforming the U.S. Aggregate Bond Index (AGG, BND). It is a dynamic allocation model in a bond universe, inspired by readings on tactical asset allocation, mostly articles and white papers by Mebane Faber and Gary Antonacci. It belongs to the dual-momentum category: the absolute momentum indicator is calculated on a 10-month period, and the relative strength indicator is calculated on a trailing quarter. I think simplicity is a factor of robustness.

Evolution of long-term treasury bonds after QE

QE3 purchases were halted on 10/29/2014. The next two charts plot the 20-year treasury rate and the 20+ year treasury bond ETF (NYSEARCA:TLT).

20-Year Treasury Bond rate, from St. Louis Fed database

TLT price action, from Finviz

The end of QE has not resulted in a total collapse of TLT as expected by some analysts, but it has brought in bonds more volatility with large swings and a slightly bearish direction. To simplify calculations and comparisons, we will consider hereafter that the post-QE period starts in 2015.

Performance since launch

I launched the first version of bond rotation for subscribers on another platform in December 2013, and then I have added it in my Seeking Alpha contribution as a part of Quantitative Risk & Value. Since 2013, the set of possible holdings has been slightly modified but the basic rules are still the same. The next table shows the returns of the strategy, since it is available to subscribers, compared with BND (the benchmark) and TLT. ETF dividends are reinvested.

2018*

2017

2016

2015

2014

2014-2018

Post QE 2015-2018

Bond Rotation

-0.3%

6.3%

10.8%

-4.0%

8.2%

21.9%

12.7%

BND

-1.8%

3.5%

2.5%

0.4%

6.0%

10.9%

4.6%

TLT

-5.79%

9.10%

-0.28%

-0.98%

27.9%

29.8%

1.6%

* 2018 YTD on 9/22

The table shows total returns by year since inception and post QE. The Bond Rotation Model has fulfilled its objective, beating BND by 11% in total return since 2014 and by 8% post QE. It has beaten TLT by 11% post QE but underperformed it in 2014. We can also have a look at simulations on past data.

Backtests

Results above are out-of-sample (after launching the strategy and making it available to subscribers). In a backtest starting in May 2009, the bond rotation would have returned over 17% annualized, an annualized excess return of 13% over BND. During the last bear market (1/1/2008 to 5/1/2009), it would have returned 8.5% annualized, beating BND by 4.7% (with 2 missing ETFs due to inception dates).

Possible holdings

The current list of possible holdings is in the table below. The list may be revised depending on new ETFs and liquidity.

Ticker

Name

BND

Vanguard Total Bond Market ETF

CWB

SPDR Barclays Capital Convertible Bond ETF

IEF

iShares 7-10 Year Treasury Bond ETF

JNK

SPDR Bloomberg Barclays High Yield Bond ETF

MUB

iShares National AMT-Free Muni Bond ETF

SHY

iShares 1-3 Year Treasury Bond ETF

TLT

iShares 20+ Year Treasury Bond ETF

WIP

SPDR DB International Government Inflation-Protected Bond ETF

Like for all tactical allocation strategies, the number of possible holdings is critical: having too many ETFs in the list brings a risk of whipsaw and higher transaction costs, while having not enough brings a risk of missing trends in asset sub-categories.

Conclusion

A tactical bond allocation, and more specifically this Bond Rotation model, may be an interesting strategy for:

  • Bond investors trying to beat bond benchmarks.

  • Investors willing to keep a significant exposure in bonds despite rising rates.

  • Investors following any kind of stock/bond allocation (80/20, 60/40, 50/50...).

Real performance in the recent (and short) post-QE period gives clues that the model might continue outperforming its benchmark in a rising rate environment. Simulated performances during the 2008 crash and the 2009-2013 bull period show that the model was able to outperform its benchmark and provide positive returns in two different market regimes. However, past performance, real or simulated, is never a guarantee of future results.

Disclosure: I/we 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.

Additional disclosure: I stopped trading this strategy a few months ago due to U.S. ETF trading issues for EU citizens (PRIIPS regulation). I should trade it again when I find a solution with acceptable costs.