Note: an enhanced version of this strategy, BOND-COMP, is now part of the Economic Pulse Newsletter
Most tactical asset allocation strategies focus on equites. That’s completely understandable. They are the highest return asset class over the long run and that is where most of the TAA research has been done. The principle factor that most TAA strategies exploit, momentum, also exists in bonds. My TAA bond strategy, see my latest update on the strategy here (you can also find the strategy on AllocateSmartly), exploits momentum in bonds to improve absolute and risk-adjusted returns over the benchmark. But, as usual, there is more than one way to approach tactical allocation in bonds. In this post I’ll take a look at two TAA bond strategies that use a simple market timing strategy based on economic indicators to allocate amongst different bond types.
Both strategies are based on using economic indicators to determine high probability risk-on periods and risk-off periods for risk-assets. I wrote a four part series a while back on using economic indicators to time entry and exits into risk assets (part 1, part 2, part 3, part 4). For the first strategy, called Bond UI1(unemployment rate indicator), we’ll use the simple monthly SPY-UI indicator defined in part 1 of the series to invest in either credit risk bonds (HYG, EMB, BNDX, LQD) or government bonds (SHY, IEF, TLT). When the indicator is risk-on the model will be invested in credit risk bonds equal weighted and when the indicator is risk-off the model will be invested in government bonds equal weighted. The second strategy, Bond UI2, is similar but just more concentrated using HYG to represent credit risk and IEF to represent government bonds. That’s it. Simple. Straight forward. These two strategies just use absolute momentum to switch among risky bonds and risk-free bonds and no relative momentum. This approach is different from the one I use in the TAA Bond 3 strategy that use only relative momentum among bond types to make investment decisions. One of best things about this new approach is that it results in much lower turnover than TAA strategies that use relative momentum. Let’s take a look at how both of these perform versus the bond benchmark and two other TAA bond strategies. All models and tests were done with P123.
The table below shows the performance of the two new TAA bond strategies vs TAA Bond 3, Tactical Credit (which I described in my last post on TAA Bond 3), and the bond benchmark (BND) from Jan 1999 through July 12, 2019. For each table I have also added the average US 10 year yield over that time period.
Pretty good results in terms of raw performance and risk-adjusted performance. Both bond UI strategies beat the relative momentum TAA strategies and the benchmark. Now, let’s take a look at performance over a few sub periods. The table below breaks down the overall time period into 3 sub periods: year 2000 economic cycle (1999 to 2007), the year 2008 economic cycle (2008 to now), and the period from mid July 2012 to October 2018 which saw the US 10 year note more than double in yield (from 1.53% to 3.15%).
Again, very good result across the board. Notice how the outperformance of the TAA approaches over the bond benchmark holds up pretty well over the two economic cycles, 1999 and 2008, despite yields being much lower in the 2008 cycle. Also, even in the 6 year period (2012 to 2018) where rates doubled the TAA strategies performed remarkably well. Finally, note how Bond UI CRED/GOV outperformed over the 2008 cycle due to its exposure to international bonds which the other strategies do not have. Overall, due to its returns, low drawdowns, high sharpe ratio, and very low turnover I think the Bond UI CRED/GOV strategy is the best option among the strategies.
That’s it for this post. Using the economic indicators as the basis for tactical asset allocation bond strategies performs quite well and better than strategies that just use momentum to make allocation decisions. In my next post, I’ll take this approach one step further by combining value, momentum, and economic indicators to bond closed-end funds (CEFs) to further enhance bond returns to make them more equity like. Stay tuned…
P.S. Using a set of economic indicators to determine the risk-on risk off periods works even better. The SPY-COMP indicator in the Economic Pulse Newsletter further improves the performance of these approaches. See here for more information on the newsletter.