Bonds

It is plausible that high-yield corporate bonds have return characteristics substantially different from those of other asset classes, and therefore represent a good diversification opprotunity. To check, we add iShares iBoxx $ HY Corp Bond Fund (HYG) to the following mix of asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

First, per the findings of “Asset Class Diversification Effectiveness Factors”, we measure the average monthly return for HYG and the average pairwise correlation of HYG monthly returns with the monthly returns of the above assets. Then, we compare cumulative returns and basic monthly return statistics for equally weighted (EW), monthly rebalanced portfolios with and without HYG. We ignore rebalancing frictions, which would be about the same for the alternative portfolios. Using adjusted monthly returns for HYG and the above nine asset class proxies from May 2007 (first return available for HYG) through January 2012 (57 monthly returns), we find that: More…

Treasury Inflation-Protected Securities (TIPS), offering an explicit inflation hedge, may be an attractive asset for strategic diversification. To check, we add iShares Barclays TIPS Bond Fund (TIP) to the following mix of asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

First, per the findings of “Asset Class Diversification Effectiveness Factors”, we measure the average monthly return for TIP and the average pairwise correlation of TIP monthly returns with the monthly returns of the above assets. Then, we compare cumulative returns and basic monthly return statistics for equally weighted (EW), monthly rebalanced portfolios with and without TIP. We ignore rebalancing frictions, which would be about the same for the alternative portfolios. Using adjusted monthly returns for TIP and the above nine asset class proxies from September 2006 (first return available for all nine of the above in the momentum strategy test) through January 2012 (65 monthly returns), we find that: More…

Do aggregate corporate earnings predict bond market returns? In his January 2012 paper entitled “Aggregate Earnings and Corporate Bond Markets”, Xanthi Gkougkousi investigates the relationship between aggregate earnings and corporate bond market returns. Using quarterly aggregate earnings for a broad sample of U.S. stocks with fiscal years ending in March, June, September and December and total quarterly returns for ten U.S. corporate bond indexes during January 1973 through December 2010 (360,614 firm-quarter observations), he finds that: More…

A subscriber asked: “Everyone says I should not invest in bonds today because the interest rate is so low (and inflation is daunting). But real bond returns over the last 30 years are great, even while interest rates are low. Could you analyze why bonds do well after, but not before, 1981?” Total bond returns consist of a yield component and a change in market price component. Conveniently, Damodaran Online offers estimated annual total returns for 10-year U.S. Treasury notes (T-note) since 1928. Using annual total returns for T-notes and the lagged 12-month U.S. inflation rate during 1928 through 2010, we find that: More…

Should investors believe in the superiority of stocks for the long run and bonds for the short run? In his December 2011 paper entitled “Stocks, Bonds, Risk, and the Holding Period: An International Perspective”, Javier Estrada examines how the absolute and relative risks of stocks and bonds evolve as investment horizon grows (time diversification). Considering both annual and cumulative returns and various measures of variability/risk, he focuses on the question of whether stocks become less risky than bonds for long holding periods. Using annual total returns for stocks and bonds in 19 countries during 1900 through 2009, he finds that: More…

A reader observed and inquired:

“I frequently see a certain cliche in trading blogs…that, when the bond markets and the equity markets disagree, trust the bond markets. Do you know of any evidence for this? The article ‘What Leads to Market Bottoms?’ is one example out of dozens: ‘…possibly the most reliable indicator of a turn for the better in the fortunes of the stock market is the corporate bond market. Napier – who has published this research in the book Anatomy of the Bear: lessons from Wall Street’s four great bottoms (CLSA Books, 2005) – points out that corporate bonds have a superb track record of anticipating recovery.

• US corporate bonds bottomed in June 1921. US equities bottomed in August 1921.
• US corporate bonds bottomed in May 1932. US equities bottomed in July 1932.
• US corporate bonds bottomed in February 1982. US equities bottomed in August 1982.

Bond market investors aren’t stupid. There is good evidence that the bond market is altogether shrewder than the stock market.’”

Testing the hypothesis that bond market bottoms (bond yield tops) reliably anticipate stock market bottoms requires operational definitions of “top” and “bottom.” Consider definitions based on two conditions: (1) a top (bottom) must be the maximum (minimum) value over the preceding XX months; and, (2) this value must persist as the maximum (minimum) as this XX-month window rolls at least through the next YY months. Using monthly levels of Moody’s yield on seasoned Aaa corporate bonds for all industries and monthly closes of the Dow Jones Industrial Average (DJIA) during October 1928 through October 2011 (about 83 years) for two XX-YY scenarios, we find that: More…

The Federal Reserve states that open market operations regulate “the aggregate level of balances available in the banking system,” thereby keeping the effective Federal Funds Rate close to a target level. The operations are predominantly repurchases, whereby the Federal Reserve provides liquidity. Do Permanent Open Market Operations (POMO) systematically affect the nominal or real yields on 10-year Treasury notes (T-notes)? Using data for accepted Treasuries repurchases via POMO during August 2005 through May 2011 to date (323 transactions over 70 months, with May 2011 a partial month) and contemporaneous monthly T-note yields and lagged inflation rates, we find that: More…

As implied in “Mirror Image Seasonality for Stocks and Treasuries?”, have bonds recently been better than stocks during the “Sell-in-May” months of June through October? Are the behaviors of government and corporate bonds over this interval similar? Using dividend-adjusted monthly prices for the PIMCO Long-Term US Government A (PFGAX), PIMCO High Yield A (PHDAX) and for SPDR S&P 500 (SPY) during November 1998 (the earliest available for PFGAX) through April 2011, we find that: More…

Can Treasury Inflation-Protected Securities (TIPS), with principal indexed to the U.S. non-seasonally adjusted Consumer Price Index for all urban consumers (CPI), play a valuable role in asset class diversification? In the January 2011 draft of their paper entitled “Optimal Portfolio Choice in Real Terms: Measuring the Benefits of TIPS”, Alvaro Cartea, Jonatan Saul and Juan Toro apply mean-variance optimization to measure the empirical diversification benefits of TIPS for long-term and short-term investors with portfolios including various combinations of equities, nominal Treasuries, commodities and real estate. Using nominal monthly returns for all TIPS issued before August 2009, grouped by maturity, for the period March 1997 through March 2010 (157 monthly observations) and contemporaneous returns for nominal U.S. Treasury instruments, U.S. stocks, commodities and U.S. home prices, they find that: More…

How effectively and consistently do equities, bonds, oil, gold and the dollar serve as hedges and safe havens for each other? In their September 2010 paper entitled “Hedges and Safe Havens – An Examination of Stocks, Bonds, Oil, Gold and the Dollar”, Cetin Ciner, Constantin Gurdgiev and Brian Lucey investigate pairwise hedging and safe haven relationships among these five major assets/asset classes. The define an asset as a hedge (safe haven) for another if respective returns are uncorrelated or negatively correlated on average over the long term (during relatively short intervals of stress). They define the long term (relatively short intervals) as their entire sample period (rolling four-month subperiods). They define intervals of stress as returns in the lowest fourth of observations. Using daily levels of the S&P 500 Index, an index of 10-year Treasuries, nearest-month gold and oil futures and the Federal Reserve Nominal Trade Weighted Effective Index for the dollar from January 1985 through October 2009 (nearly 25 years), they find that: More…