December 23, 2014

Dual Momentum Fixed Income

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 (DMFI) model switches monthly between the strongest one of the following indexes: Barclays Capital U.S. Credit Bonds, Barclays Capital U.S. Corporate High Yield Bonds, Barclays Capital U.S. Mortgage Backed Securities, and 90 day U.S. Treasury bills.

The reason for choosing credit bonds instead of U.S. Treasury bonds for the core of this model is because of  portfolio theory principles. There is a risk premium associated with credit bonds that is absent from U.S. Treasury obligations. 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 U.S. Treasury bills when their returns are higher than bonds) to a credit bond portfolio reduces portfolio stress, which further eliminates systematic 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:


HI YIELD
CREDIT
 MBS
TBILLS
DMFI
Annual Return
9.8
8.6
7.9
4.1
12.0
Annual Std Dev
8.5
5.5
4.0
0.8
5.8
Sharpe Ratio
0.73
0.94
1.13
1.10
1.43
Max Drawdown
-33.3
-7.3
-7.8
0
-5.7
% of DMFI Profits
59
20
14
7
100
% of Occurrences
47
24
16
13
100
Avg Credit Rating
B
BBB
AAA
AAA
*
Avg Yrs Duration
4.5
7.1
0.3
0.3
*


Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our website Performance and Disclaimer pages for additional disclosures.
 
What is especially interesting is that DMFI returns are more than 200 basis points higher than the returns of high yield bonds, while DFMI maximum drawdown is lower than that of investment grade credit bonds. With average years to maturity of 4.5, 7.1, and 4.3 for the high yield, credit, and mortgage backed bond indexes respectfully, dual momentum achieves these impressive results without having to assume a lot of duration risk and interest rate volatility. Instead, DMFI navigates effectively along a relatively short area of both the yield and quality curves, while simultaneously avoiding the high 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. 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 desire 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.