New York Fed - Beating The Bond Marketplace Pose Alongside Momentum

J. Benson Durham of the New York Fed has late published a staff study "Momentum as well as the Term Structure of Interest Rates". The study describes a portfolio construction technique that is long-only, duration neutral versus the index, yet it generates upwards to 120 set down points of annual excess return. I explicate what I recall explains this rigid performance, although it would require detailed testing to validate this. I conclude with a less technical give-and-take of how this relates to the concept of marketplace efficiency.

How I Would Approach This Analysis

The solely reliable agency of testing the results inwards a newspaper similar this is to replicate it yourself. Paranoia tin forcefulness out live a useful feature for fiscal analysts. The results inwards the article facial expression reasonable, as well as I desire to assume that J. Benson Durham wants to let on right results. Nevertheless, relative performance analysis is tricky, as well as I would ever desire to validate the calculations before fifty-fifty starting to recall virtually putting the results into practice.

Although he does facial expression at the results inwards a issue of ways, I would facial expression really carefully at the correlation betwixt excess returns as well as the management of involvement rates, for reasons I utter over below. I would also live mainly interested inwards decomposing the results into basic strategies.

Luckily for me, I do non receive got the total supply information to do that painstaking analysis, as well as and so that run is left every bit an exercise for the reader. I assume hither that his presented results are correct.

Summary Of The Results

Although he looked at strategies that allow brusque selling, I volition utter over the version of his strategy that could live applied to a long-only investment mandate. He uses the Barclays Capital total supply indices for the Treasury marketplace (he also applied the technique to other markets). The strategy is implemented yesteryear changing the weighting alongside maturity buckets (1- to 3-, 3- to 5-, 5- to 7-, 7- to 10-, 10- to 20-, as well as 20- to 30-year maturities). Constraints are added such that:

• the duration of the portfolio is the same every bit the duration of the index;
• the portfolio weighting on each maturity bucket is betwixt 0 as well as 1. 

Using those constraints, the portfolio weights are determined yesteryear optimising what I refer to every bit a the portfolio prospective return. The prospective supply for a maturity bucket is the the total supply for the sub-index for the yesteryear N months. In other words, yesteryear returns are assumed to live predictive of futurity (relative) performance. (Note that since nosotros are interested inwards relative performance, nosotros do non attention virtually the grade of the "prospective" supply for a maturity bucket, rather what it is relative to the other maturity buckets.) The most interesting choices for the  "lookback period" (N) were virtually 12 months (results are presented for a issue of choices for N).

The portfolio weights are relatively stable over time. During most of the sample menstruum (December 1996 - July 2013) the mass of the model portfolio was inwards the belly of the crimp (5- to 10-years). But during the in conclusion xviii months of the period, the portfolio switched over to a barbell, with holdings inwards the 1-/3-year as well as 10-/20-year buckets. This modify of demeanour seems predictable from basic yield crimp analysis, every bit I utter over below.

The newspaper covers a lot of solid set down inwards attempting to explicate the results. But I recall the results are readily understood using concepts that are good known to practitioners.

Duration Neutral Positions Can Still Be Directional

Duration neutral strategies tin forcefulness out even as well as so live directional. The nautical chart inwards a higher house gives a classic example, the 10-/20-year gradient trade.

• The x-axis shows the 1-month modify inwards the 10-year Treasury yield (1994-2014).
• The y-axis shows the corresponding 1-month modify inwards the 10-year/20-year slope.

The human relationship is weakened yesteryear non isolating exceptional trading regimes, but nosotros reckon that on average, the 10-/20-year gradient steepens yesteryear xiv set down points for every 100 set down points the 10-year yield falls. In other words, you lot await to brand coin on a "steepener" if rates fall, fifty-fifty though you lot are duration neutral. Added to the directional modify inwards slope, a 10-/20-year steepener volition ship positively, as well as and so you lot volition brand coin if at that topographic point is no sell-off.

The supposition of parallel yield crimp shocks are so non able to correctly characterise risks for fixed income trading. Value-at-Risk (VaR) approaches do a improve job, every bit they should capture these empirical yield crimp regularities. 

An alternative agency of seeing this is to purpose a Principal Component Analysis (PCA). The showtime element loading on 20+-year maturities is typically lower than for the 10-year maturity, at to the lowest degree inwards environments where the forepart terminate is good away from zero. PCA analysis is used sometimes inwards the construction of "butterfly" trades to eliminate the directionality inside the butterfly. (A butterfly is a 3-legged trade, inwards which you lot merchandise a bond of 1 maturity versus a pair of bonds with longer/shorter maturities.)

But the PCA construction changes if the policy charge per unit of measurement is stuck at 0%. This was seen inwards Japan, as well as the United States of America of America recently. Therefore, I translate the modify inwards the model portfolio at the terminate of the sample menstruum every bit a reflection of the changing PCA factor. Since the forepart terminate is similar a shot locked down, you lot take away to extend to asset bonds with a duration longer than that of the index to generate a directional bias. If you lot desire to agree bonds with a duration longer than the index, you lot are forced to also agree short-dated bonds to live duration-matched. Hence the "barbell" model portfolio construction at the terminate of the period.

Carry And Rolldown Persistence

The modern (post-1980s) bond market* is characterised yesteryear iv principal modes of operation:

1. Panic. The somebody sector blows itself upwards inwards roughly fashion, as well as the cardinal banking firm slashes rates inwards a panic. Bond yields dive lower, but they typically overshoot for technical reasons (short squeeze, convexity hedging), as well as also right sharply.
2. Grinding Bull Market. Central banks expire along the policy charge per unit of measurement at "unsustainable" depression yield levels for years, causing slap-up hand-wringing alongside the difficult coin crowd. Bond yields creep lower, as well as ship as well as rolldown trades impress large returns.
3. The Carry Correction. It is clear that the cardinal banking firm volition finally tighten monetary policy, as well as the bond marketplace has a fairly fierce sell off to toll the path of futurity charge per unit of measurement hikes.
4. Long Slog Higher. Plodding charge per unit of measurement hikes of 25 set down points per coming together pick out place. Since these receive got already been largely priced, bond marketplace total returns oscillate slightly, although at that topographic point is a modest bearish bias to bond returns.

The mass of yield changes give off during inwards modes (1) as well as (3), but those are brusque periods. Most of the time, nosotros are inwards modes (2) as well as (4). The menstruum 2010-mid 2013 is an instance of the persistence of the "Grinding Bull Market" mode. There was a consensus stance that charge per unit of measurement hikes were imminent for most of that period, as well as and so at that topographic point were considerable jeopardy premiums built into the belly of the curve.

The momentum strategy used inside J. Benson Durham's newspaper volition largely pick upwards those long-lasting periods of carry-and-rolldown dominance. (The charge per unit of measurement hike periods are also fairly persistent, but stand upwards for a smaller proportion of the total fourth dimension interval.) This is because the lookback menstruum is non a brusque menstruum similar 1-3 months, rather it is looking at relative performance over a 12-month period, which is longer than the short-lived bull as well as ship modes. As a result, it is no accident that most of the time, the portfolio is bulleted, which gives the optimal carry-and-rolldown for a fixed duration. This makes this version of momentum really dissimilar than a technical analysis momentum indicator which is based on things similar moving average crossovers. Instead, it is picking upwards relatively persistent relative outperformance.

Term Premia

The article brings inwards roughly analysis using arbitrage-free term construction models. I am non a fan of those models, every bit they are likewise complex for whatever value they add. But if those models run at all, they should live able to generate a term construction of term premia. The excess returns for bonds inwards the belly of the crimp are the final result of rolling downwardly the term premia structure. 

In practice, traders obsess virtually the ship as well as rolldown of trades. Carry as well as rolldown should live highest at the points of the crimp where the term premia are the most favourable. Therefore, they are achieving virtually the same terminate final result every bit the arbitrage-free term construction models, without the analytical overhead (and model instability). This is despite the fact that a superficial reading of marketplace efficiency would say that "carry as well as rolldown" should non live element inwards choosing positions.

Market Efficiency

Tom Hickey characterised this newspaper at Mike Norman Economics as "More nails inwards the coffin of EMH [Efficient Market Hypothesis- BR]". I could fence both for as well as against this view, depending on the context.

The declaration that this final result does non violate marketplace efficiency is that the strategy is taking directional risk, as well as the outperformance is compensation for that. Additionally, the menstruum involved was a bond bull market, as well as so a strategy with a bullish directional bias would live expected to outperform. Most reasonable definitions of marketplace efficiency pick out that you lot tin forcefulness out earn a supply premium for taking diverse risks, as well as and so the results may non live likewise threatening for the EMH.

The arguments that this article shows that markets are non efficient are to a greater extent than interesting, but are to a greater extent than controversial.

• The argue that nosotros receive got to command to heavily for directionality is because nosotros were inwards a multi-decade bond bull market. This bull marketplace is evidence that at that topographic point receive got been persistent massive involvement charge per unit of measurement forecast errors yesteryear marketplace participants. Expected term premia should live likewise modest to explicate bond outperformance of cash.
• The portfolio construction is evidence that the term construction of term premia seems to live priced somewhat inefficiently. This could live the final result of bond marketplace segmentation.

Although it may seem surprising that at that topographic point is as well as so much marketplace inefficiency inside the Treasury market, it may live a side final result of "modern" portfolio analysis. If you lot ran a fund that took strategic duration positions over the yesteryear twosome of decades as well as you lot outperformed your benchmarks, you lot would receive got to receive got been long duration for most of the time. This bias ends upwards looking similar "beta".

To pick out an exaggerated  example, you lot could receive got been at 110% of benchmark duration most of the fourth dimension during an extended bull marketplace period. What you lot could detect is that your performance is best approximated as:

Performance = 110% × Index Performance + 0 set down points.

In other words, your performance is all "beta" (beta = 1.1) as well as no "alpha" (alpha = 0), despite outperforming the index. The solely agency to live sure as shooting to "add alpha" is to tactically fourth dimension the markets, as well as so that you lot tin forcefulness out somehow ever live profitable every calendar month or quarter. (Technically, you lot take away to interruption upwards the correlation of your portfolio returns with the index returns.)

Although it would live wonderful to live able to guess the management of the manic-depressive bond marketplace marketplace every unmarried month, the odds of having that mightiness are somewhat low. As a result, efforts are expended inwards every conceivable other management inwards guild to trounce the index: credit positioning, choice strategies, relative value trades. Since these positions tin forcefulness out outperform inwards a vogue that is uncorrelated with the index overall return, whatever outperformance is to a greater extent than probable to classified every bit "alpha". This skewed incentive construction inside the fiscal manufacture is what may allow exaggerated term premia to persist - investors lack the incentive to pick out the directional jeopardy needed to crunch them out..

Concluding Remarks

The article is interesting, although I would pick out the management of the analysis to a greater extent than towards the human relationship betwixt the model portfolio as well as the management of involvement rates. The characterisation of the strategy every bit "momentum" is somewhat misleading, every bit it is picking upwards persistent outperformance. Finally, it offers a novel perspective on the inquiry of bond marketplace efficiency.

Footnote:

* The post-1980s bond marketplace has dissimilar tactical characteristics than before eras. This partly reflects the structural changes inwards the economy, but it also reflects the greater technical competence of bond marketplace participants (that is mainly the final result of inexpensive digital computers). Strategists who do non brand purpose of forwards charge per unit of measurement information are at a huge disadvantage versus their "forward aware" competitors.

See Also:

• My give-and-take of historical term premia.

(c) Brian Romanchuk 2014