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Bonds have two price components, yield and response of price to prevailing interest rates. How much of a return premium should investors in bonds expect? How can investors enhance this premium? These blog entries examine investing in bonds.

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Bonds During the Off Season?

As implied in “Mirror Image Seasonality for Stocks and Treasuries?”, are bonds better than stocks during the “Sell-in-May” months of May through October? Are behaviors of government, corporate investment grade and corporate high-yield bonds over this interval similar? To investigate, we test seasonal behaviors of:

SPDR S&P 500 (SPY)
Vanguard Intermediate-Term Treasury (VFITX)
Fidelity Investment Grade Bond (FBNDX)
Vanguard High-Yield Corporate Bond (VWEHX)

Using dividend-adjusted monthly prices for these funds during January 1993 (limited by SPY) through July 2018, we find that: Keep Reading

SACEVS with Quarterly Allocation Updates

Do quarterly allocation updates for the Best Value and Weighted versions of the “Simple Asset Class ETF Value Strategy” (SACEVS) work as well as monthly updates? These strategies allocate funds to the following asset class exchange-traded funds (ETF) according to valuations of term, credit and equity risk premiums, or to cash if no premiums are undervalued:

3-month Treasury bills (Cash)
iShares 20+ Year Treasury Bond (TLT)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
SPDR S&P 500 (SPY)

Changing from monthly to quarterly allocation updates does not sacrifice information about lagged quarterly S&P 500 Index earnings, but it does sacrifice currency of term and credit premiums. To assess alternatives, we compare cumulative performances and the following key metrics for quarterly and monthly allocation updates: gross compound annual growth rate (CAGR), gross maximum drawdown (MaxDD) and annual returns and volatilities. Using monthly dividend-adjusted closes for the above ETFs during September 2002 (earliest alignment of months and quarters) through June 2018, we find that:

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Simple Term Structure ETF/Mutual Fund Momentum Strategy

Does a simple relative momentum strategy applied to tradable U.S. Treasury term structure proxies produce attractive results by picking the best duration for exploiting current interest rate trend? To investigate, we run short-term and long-term tests. The short-term test employs four exchange-traded funds (ETF) to represent the term structure:

SPDR Barclays 1-3 Month T-Bill (BIL)
iShares 1-3 Year Treasury Bond (SHY)
iShares Barclays 7-10 Year Treasury Bond (IEF)
iShares Barclays 20+ Year Treasury Bond (TLT)

The second test employs three Vanguard mutual funds to represent the term structure:

Vanguard Short-Term Treasury Fund (VFISX)
Vanguard Intermediate-Term Treasury Fund (VFITX)
Vanguard Long-Term Treasury Fund (VUSTX)

For each test, we allocate all funds at the end of each month to the fund with the highest total return over a specified ranking (lookback) interval, ranging from one month to 12 months. To accommodate the longest lookback interval, portfolio formation commences 12 months after the start of the sample. We focus on compound annual growth rate (CAGR) and maximum drawdown (MaxDD) as key performance metrics. Using monthly dividend-adjusted closing prices for BIL since May 2007, for SHY, IEF and TLT since July 2002 and for VFISX, VFITX and VUSTX since October 1991, all through June 2018, we find that: Keep Reading

Simple Debt Class Mutual Fund Momentum Strategy

A subscriber requested confirmation of the performance of a simple momentum strategy that each month selects the best performing debt mutual fund based on total return over the past three months. To investigate, we test a simple strategy on the following 12 mutual funds (those with the longest histories from a proposed list of 14 funds):

T. Rowe Price New Income (PRCIX)
Thrivent Income A (LUBIX)
Vanguard GNMA Securities (VFIIX)
T. Rowe Price High-Yield Bonds (PRHYX)
T. Rowe Price Tax-Free High Yield Bonds (PRFHX)
Vanguard Long-Term Treasury Bonds (VUSTX)
T. Rowe Price International Bonds (RPIBX)
Fidelity Convertible Securities (FCVSX)
PIMCO Short-Term A (PSHAX)
Fidelity New Markets Income (FNMIX)
Eaton Vance Government Obligations C (ECGOX)
Vanguard Long-Term Bond Index (VBLTX)

We consider a strategy that allocates funds at the end of each month based on total returns over a specified ranking (lookback) interval to the Top 1, equally weighted (EW) Top 2, EW Top 3, EW Top 4 or EW Top 5 funds. We determine the first winners in November 1988 so that at least nine funds are available for lookback interval sensitivity testing. As a benchmark, we use the equally weighted and monthly rebalanced combination of all available funds (EW All). Using monthly dividend-adjusted closing prices for the 12 mutual funds from inceptions through June 2018, we find that: Keep Reading

SACEVS Input Risk Premiums and EFFR

The “Simple Asset Class ETF Value Strategy” seeks diversification across a small set of asset class exchanged-traded funds (ETF), plus a monthly tactical edge from potential undervaluation of three risk premiums:

  1. Term – monthly difference between the 10-year Constant Maturity U.S. Treasury note (T-note) yield and the 3-month Constant Maturity U.S. Treasury bill (T-bill) yield.
  2. Credit – monthly difference between the Moody’s Seasoned Baa Corporate Bonds yield and the T-note yield.
  3. Equity – monthly difference between S&P 500 operating earnings yield and the T-note yield.

Premium valuations are relative to historical averages. How might this strategy react to increases in the Effective Federal Funds Rate (EFFR)? Using monthly values of the three risk premiums, EFFR, total 12-month U.S. inflation and core 12-month U.S. inflation during July 2000 (limited by availability of EFFR) through May 2018 (215 months), we find that: Keep Reading

Benefits of Volatility Targeting Across Asset Classes

Does volatility targeting improve Sharpe ratios and provide crash protection across asset classes? In their May 2018 paper entitled “Working Your Tail Off: The Impact of Volatility Targeting”, Campbell Harvey, Edward Hoyle, Russell Korgaonkar, Sandy Rattray, Matthew Sargaison, and Otto Van Hemert examine return and risk effects of long-only volatility targeting, which scales asset and/or portfolio exposure higher (lower) when its recent volatility is low (high). They consider over 60 assets spanning stocks, bonds, credit, commodities and currencies and two multi-asset portfolios (60-40 stocks-bonds and 25-25-25-25 stocks-bonds-credit-commodities). They focus on excess returns (relative to U.S. Treasury bill yield). They forecast volatility using realized daily volatility with exponentially decaying weights of varying half-lives to assess sensitivity to the recency of inputs. For most analyses, they employ daily return data to forecast volatility. For S&P 500 Index and 10-year U.S. Treasury note (T-note) futures, they also test high-frequency (5-minute) returns transformed to daily returns. They scale asset exposure inversely to forecasted volatility known 24 hours in advance, applying a retroactively determined constant that generates 10% annualized actual volatility to facilitate comparison across assets and sample periods. Using daily returns for U.S. stocks and industries since 1927, for U.S. bonds (estimated from yields) since 1962, for a credit index and an array of futures/forwards since 1988, and high-frequency returns for S&P 500 Index and 10-year U.S. Treasury note futures since 1988, all through 2017, they find that:

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Testing a Countercyclical Asset Allocation Strategy

“Countercyclical Asset Allocation Strategy” summarizes research on a simple countercyclical asset allocation strategy that systematically raises (lowers) the allocation to an asset class when its current aggregate allocation is relatively low (high). The underlying research is not specific on calculating portfolio allocations and returns. To corroborate findings, we use annual mutual fund and exchange-traded fund (ETF) allocations to stocks and bonds worldwide from the 2018 Investment Company Fact Book, Data Tables 3 and 11 to determine annual countercyclical allocations for stocks and bonds (ignoring allocations to money market funds). Specifically:

  • If actual aggregate mutual fund/ETF allocation to stocks in a given year is above (below) 60%, we set next-year portfolio allocation below (above) 60% by the same percentage.
  • If actual aggregate mutual fund/ETF allocation to bonds in a given year is above (below) 40%, we set next-year portfolio allocation below (above) 40% by the same percentage.

We then apply next-year allocations to stock (Fidelity Fund, FFIDX) and bond (Fidelity Investment Grade Bond Fund, FBNDX) mutual funds that have long histories. Based on Fact Book annual publication dates, we rebalance at the end of April each year. Using the specified actual fund allocations for 1984 through 2017 and FFIDX and FBNDX May through April total returns and April 1-year U.S. Treasury note (T-note) yields for 1985 through 2018, we find that: Keep Reading

Ziemba Party Holding Presidency Strategy Update

“Exploiting the Presidential Cycle and Party in Power” summarizes strategies that hold small stocks (large stock or bonds) when Democrats (Republicans) hold the U.S. presidency. How has this strategy performed in recent years? To investigate, we consider three strategy alternatives using exchange-traded funds (ETF):

  1. D-IWM:R-SPY: hold iShares Russell 2000 (IWM) when Democrats hold the presidency and SPDR S&P 500 (SPY) when Republicans hold it.
  2. D-IWM:R-LQD: hold IWM when Democrats hold the presidency and iShares iBoxx Investment Grade Corporate Bond (LQD) when Republicans hold it.
  3. D-IWM:R-IEF: hold IWM when Democrats hold the presidency and iShares 7-10 Year Treasury Bond (IEF) when Republicans hold it.

We use calendar years to determine party holding the presidency. As benchmarks, we consider buying and holding each of SPY, IWM, LQD or IEF and annually rebalanced portfolios of 60% SPY and 40% LQD (60 SPY-40 LQD) or 60% SPY and 40% IEF (60 SPY-40 IEF). We consider as performance metrics: average annual excess return (relative to the yield on 1-year U.S. Treasury notes at the beginning of each year); standard deviation of annual excess returns; annual Sharpe ratio; compound annual growth rate (CAGR); and, maximum annual drawdown (annual MaxDD). We assume portfolio switching/rebalancing frictions are negligible. Except for CAGR, computations are for full calendar years only. Using monthly dividend-adjusted closing prices for the specified ETFs during July 2002 (limited by LQD and IEF) through April 2018, we find that:

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Worldwide Long-run Returns on Housing, Equities, Bonds and Bills

How do housing, equities and government bonds/bills perform worldwide over the long run? In their February 2018 paper entitled “The Rate of Return on Everything, 1870-2015”, Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick and Alan Taylor address the following questions:

  1. What is the aggregate real return on investments?
  2. Is it higher than economic growth rate and, if so, by how much?
  3. Do asset class returns tend to decline over time?
  4. Which asset class performs best?

To do so, they compile long-term annual gross returns from market data for housing, equities, government bonds and short-term bills across 16 developed countries (Australia, Belgium, Denmark, Finland, France, Germany, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the UK and the U.S.). They decompose housing and equity performances into capital gains, investment incomes (yield) and total returns (sum of the two). For equities, they employ capitalization-weighted indexes to the extent possible. For housing, they model returns based on country-specific benchmark rent-price ratios. Using the specified annual returns for 1870 through 2015, they find that:

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Bond and Stock ETFs Lead-lag

Are there exploitable lead-lag relationships between bonds and stocks, perhaps because bond investors are generally better informed than stock investors or because there is some predictable stocks-bonds rebalancing cycle? To investigate, we examine lead-lag relationships between bond exchange-traded fund (ETF) returns and stock ETF returns. We consider iShares iBoxx $ Investment Grade Corporate Bond (LQD) and  iShares iBoxx $ High-Yield Corporate Bond (HYG) as liquid bond ETFs and SPDR S&P 500 (SPY) as a liquid stock ETF. Using dividend-adjusted daily, weekly and monthly returns for LQDHYG and SPY during mid-April 2007 (HYG inception) through March 2018, we find that: Keep Reading

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