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Summary­

• In this commentary we explore the application of several quantitative signals to a broad set of fixed income exposures.
• Specifically, we explore value, momentum, carry, long-term reversals, and volatility signals.
• We find that value, 3-month momentum, carry, and 3-year reversals all create attractive quantile profiles, potentially providing clues for how investors might consider pursuing higher returns or lower risk.
• This study is by no means comprehensive and only intended to invite further research and conversation around the application of quantitative styles across fixed income exposures.

In Navigating Municipal Bonds with Factors, we employed momentum, value, carry, and low-volatility signals to generate a sector-based approach to navigating municipal bonds.

In this article, we will introduce an initial data dive into applying quantitative signals to a broader set of fixed income exposures.  Specifically, we will incorporate 17 different fixed income sectors, spanning duration, credit, and geographic exposure.

• U.S. Treasuries: Near (3-Month), short (1-3 Year), mid (3-5 Year) intermediate (7-10 Year), and long (20+ Year).
• Investment-Grade Corporates: Short-term, intermediate-term, and Floating Rate corporate bonds.
• High Yield: Short- and intermediate-term high yield.
• International Government Bonds: Currency hedged and un-hedged government bonds.
• Emerging Market: Local and US dollar denominated.
• TIPs: Short- and intermediate-term TIPs.
• Mortgage-Backed: Investment grade mortgage-backed bonds.

In this study, each exposure is represented by a corresponding ETF.  We extend our research prior to ETF launch by employing underlying index data the ETF seeks to track.

The quantitative styles we will explore are:

• Momentum: Buy recent winners and sell recent losers.
• Value: Buy cheap and sell expensive.
• Carry: Buy high carry and sell low carry.
• Reversal: Buy long-term losers and sell long-term winners.
• Volatility: Buy high volatility and sell low volatility.¹

The details of each style are explained in greater depth in each section below.

Note that the analysis herein is by no means meant to be prescriptive in any manner, nor is it a comprehensive review.  Rather, it is meant as a launching point for further commentaries we expect to write.

At the risk of spoiling the conclusion, below we plot the annualized returns and volatility profiles of dollar-neutral long-short portfolios.²  We can see that short-term Momentum, Value, Carry, and Volatility signals generate positive excess returns over the testing period.

Curiously, longer-term Momentum does not seem to be a profitable strategy, despite evidence of this approach being rather successful for many other asset classes.

Source: Bloomberg; Tiingo.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees.  Total return series assumes the reinvestment of all distributions.

However, these results are not achievable by most investors who may be constrained to a long-only implementation.  Even when interpreted as over- and under-weight signals, the allocations in the underlying long/short portfolios differ so greatly from benchmark exposures, they would be nearly impossible to implement.

For a long-only investor, then, what is more relevant is how these signals forecast performance of different rank orderings of portfolios.  For example, how does a portfolio of the best-ranking 3-month momentum exposures compare to a portfolio of the worst-ranking?

In the remainder of this commentary, we explore the return and risk profiles of quintile portfolios formed on each signal.  To construct these portfolios, we rank order our exposures based on the given quantitative signal and equally-weight the exposures falling within each quintile.

Momentum

We generate momentum signals by computing 12-, 6- and 3- month prior total returns to reflect slow, intermediate, and fast momentum signals.  Low-ranking exposures are those with the lowest prior total returns, while high ranking exposures have the highest total returns.

The portfolios assume a 1-month holding period for momentum signals.  To avoid timing luck, four sub-indexes are used, each rebalancing on a different week of the month.

Annualized return and volatility numbers for the quintiles are plotted below.

A few interesting data-points stand out:

• For 12-month prior return, the lowest quintile actually had the highest total return.However, it has a dramatically lower Sharpe ratio than the highest quintile, which only slightly underperforms it.
• Total returns among the highest quintile increase by 150 basis points (“bps”) from 12-month to 3-month signals, and 3-month rankings create a more consistent profile of increasing total return and Sharpe ratio. This may imply that short-term signals are more effective for fixed income.

Source: Bloomberg; Tiingo.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees.  Total return series assumes the reinvestment of all distributions.

Carry

Carry is the expected excess return of an asset assuming price does not change.  For our fixed income universe, we proxy carry using yield-to-worst minus the risk-free rate.  For non-Treasury holdings, we adjust this figure for expected defaults and recovery.

For reasonably efficient markets, we would expect higher carry to imply higher return, but not necessarily higher risk-adjusted returns.  In other words, we earn higher carry as a reward for bearing more risk.

Therefore, we also calculate an alternate measure of carry: carry-to-risk.  Carry-to-risk is calculated by taking our carry measure and dividing it by recent realized volatility levels.  One way of interpreting this figure is as forecast of Sharpe ratio.  Our expectation is that this signal may be able to identify periods when carry is episodically cheap or rich relative to prevailing market risk.

The portfolios assume a 12-month holding period for carry signals.  To avoid timing luck, 52 sub-indexes are used, each rebalancing on a different week of the year.

We see:

• Higher carry implies a higher return as well as a higher volatility. As expected, no free lunch here.
• Carry-to-risk does not seem to provide a meaningful signal. In fact, low carry-to-risk outperforms high carry-to-risk by 100bps annualized.
• Volatility meaningfully declines for carry-to-risk quintiles, potentially indicating that this integrated carry/volatility signal is being too heavily driven by volatility.

Source: Bloomberg; Tiingo.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees.  Total return series assumes the reinvestment of all distributions.

Value

In past commentaries, we have used real yield as our value proxy in fixed income.  In this commentary, we deviate from that methodology slightly and use a time-series z-score of carry as our value of measure. Historically high carry levels are considered to be cheap while historically low carry levels are considered to be expensive.

The portfolios assume a 12-month holding period for value signals.  To avoid timing luck, 52 sub-indexes are used, each rebalancing on a different week of the year.

We see not only a significant increase in total return in buying cheap versus expensive holdings, but also an increase in risk-adjusted returns.

Source: Bloomberg; Tiingo.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees.  Total return series assumes the reinvestment of all distributions. 

Reversal

Reversal signals are the opposite of momentum: we expect past losers to outperform and past winners to underperform.  Empirically, reversals tend to occur over very short time horizons (e.g. 1 month) and longer-term time horizons (e.g. 3- to 5-years).  In many ways, long-term reversals can be thought of as a naive proxy for value, though there may be other behavioral and structural reasons for the historical efficacy of reversal signals.

We must be careful implementing reversal signals, however, as exposures in our universe have varying return dynamics (e.g. expected return and volatility levels).

To illustrate this problem, consider the simple two-asset example of equities and cash.  A 3-year reversal signal would sell the asset that has had the best performance over the prior 3-years and buy the asset that has performed the worst.  The problem is that we expect stocks to outperform cash due to the equity risk premium. Naively ranking on prior returns alone would have us out of equities during most bull markets.

Therefore, we must be careful in ranking assets with meaningfully different return dynamics.

(Why, then, can we do it for momentum?  In a sense, momentum is explicitly trying to exploit the relative time-series properties over a short-term horizon.  Furthermore, in a universe that contains low-risk, low-return assets, cross-sectional momentum can be thought of as an integrated process between time-series momentum and cross-sectional momentum, as the low-risk asset will bubble to the top when absolute returns are negative.)

To account for this, we use a time-series z-score of prior returns to create a reversal signal.  For example, at each point in time we calculate the current 3-year return and z-score it against all prior rolling 3-year periods.

Note that in this construction, high z-scores will reflect higher-than-normal 3-year numbers and low z-scores will reflect lower-than-normal 3-year returns. Therefore, we negate the z-score to generate our signal such that low-ranked exposures reflect those we want to sell and high-ranked exposures reflect those we want to buy.

The portfolios assume a 12-month holding period for value signals.  To avoid timing luck, 52 sub-indexes are used, each rebalancing on a different week of the year.

Plotting the results below for 1-, 3-, and 5-year reversal signals, we see that 3- and 5-year signals see a meaningful increase in both total return and Sharpe ratio between the lowest quintile.

Source: Bloomberg; Tiingo.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees.  Total return series assumes the reinvestment of all distributions.

Volatility

Volatility signals are trivial to generate: we simply sort assets based on prior realized volatility.  Unfortunately, exploiting the low-volatility anomaly is difficult without leverage, as the empirically higher risk-adjusted return exhibited by low-volatility assets typically coincides with lower total returns.

For example, in the tests below the low quintile is mostly comprised of short-term Treasuries and floating rate corporates.  The top quintile is allocated across local currency emerging market debt, long-dated Treasuries, high yield bonds, and unhedged international government bonds.

As a side note, for the same reason we z-scored reversal signals, we also hypothesized that z-scoring may work on volatility.  Beyond these two sentences, the results were nothing worth writing about.

Nevertheless, we can still attempt to confirm the existence of the low-volatility anomaly in our investable universe by ranking assets on their past volatility.

The portfolios assume a 1-month holding period for momentum signals.  To avoid timing luck, four sub-indexes are used, each rebalancing on a different week of the month.

Indeed, in plotting results we see that the lowest volatility quintiles have significantly higher realized Sharpe ratios.

Source: Bloomberg; Tiingo.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees.  Total return series assumes the reinvestment of all distributions.

Of the results plotted above, our eyes might be drawn to the results in the short-term volatility measure. It would appear that the top quintile has both a lower total return and much higher volatility than the 3^rd and 4^th quintiles.  This might suggest that we could improve our portfolios risk-adjusted returns without sacrificing total return by avoiding those top-ranked assets.

Unfortunately, this is not so clear cut.  Unlike the other signals where the portfolios had meaningful turnover, these quintiles are largely stable.  This means that the results are driven more by the composition of the portfolios than the underlying signals.  For example, the 3^rd and 4^th quintiles combine both Treasuries and credit exposure, which allows the portfolio to realize lower volatility due to correlation.  The highest volatility quintile, on the other hand, holds both local currency emerging market debt and un-hedged international government bonds, introducing (potentially uncompensated) currency risk into the portfolio.

Thus, the takeaway may be more strategic than tactical: diversification is good and currency exposure is going to increase your volatility.

Oh – and allocating to zero-to-negatively yielding foreign bonds isn’t going to do much for your return unless currency changes bail you out.

Conclusion

In this study, we explored the application of value, momentum, carry, reversal, and volatility signals across fixed income exposures.  We found that value, 3-month momentum, carry, and 3-year reversal signals may all provide meaningful information about forward expected returns and risk.

Our confidence in this analysis, however, is potentially crippled by several points:

• The time horizon covered is, at best, two decades, and several economic variables are constant throughout it.
• The inflation regime over the time period was largely uniform.
• A significant proportion of the period covered had near-zero short-term Treasury yields and negative yields in foreign government debt.
• Reversal signals require a significant amount of formation data. For example, the 3-year reversal signal requires 6 years (i.e. 3-years of rolling 3-year returns) of data before a signal can be generated. This represents nearly 1/3^rd of the data set.
• The dispersion in return dynamics (e.g. volatility and correlation) of the underlying assets can lead to the emergence of unintended artifacts in the data that may speak more to portfolio composition than the value-add from the quantitative signal.
• We did not test whether certain exposures or certain time periods had an outsized impact upon results.
• We did not thoroughly test stability regions for different signals.
• We did not test the impact of our holding period assumptions.
• Holdings within quantile portfolios were assumed to be equally weighted.

Some of these points can be addressed simply.  Stability concerns, for example, can be addressed by testing the impact of varying signal parameterization.

Others are a bit trickier and require more creative thinking or more computational horsepower.

Testing for the outsized impact of a given exposure or a given time period, for example, can be done through sub-sampling and cross-validation techniques.  We can think of this as the application of randomness to efficiently cover our search space.

For example, below we re-create our 3-month momentum quintiles, but do so by randomly selecting only 10 of the exposures and 75% of the return period to test.   We repeat this resampling 10,000 times for each quintile and plot the distribution of annualized returns below.

Even without performing an official difference-in-means test, the separation between the low and high quintile annualized return distributions provides a clue that the performance difference between these two is more likely to be a pervasive effect rather than due to an outlier holding or outlier time period.

We can make this test more explicit by using this subset resampling technique to bootstrap a distribution of annualized returns for a top-minus-bottom quintile long/short portfolio.  Specifically, we randomly select a subset of assets and generate our 3-month momentum signals.  We construct a dollar-neutral long/short portfolio by going long assets falling in the top quintile and short assets falling in the bottom quintile.  We then select a random sub-period and calculate the annualized return.

Only 207 of the 10,000 samples fall below 0%, indicating a high statistical likelihood that the outperformance of recent winners over recent losers is not an effect dominated by a specific subset of assets or time-periods.

While this commentary provides a first step towards analyzing quantitative style signals across fixed income exposures, more tests need to be run to develop greater confidence in their efficacy.

Source: Bloomberg; Tiingo.  Calculations by Newfound Research.  Returns are hypothetical and backtested.  Returns are gross of all management fees, transaction fees, and taxes, but net of underlying fund fees.  Total return series assumes the reinvestment of all distributions.

1. Note that this is the opposite of typical betting-against-beta and low-volatility portfolio construction.  In this construction, we are basically confirming “higher risk implies higher reward.”  More on this later.
2. Exposures are rank-weighted in the same fashion long/short portfolios were constructed in Navigating Municipal Bonds with Factors.

Corey Hoffstein

Corey is co-founder and Chief Investment Officer of Newfound Research. Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University. You can connect with Corey on LinkedIn or Twitter.