Monday, June 26, 2017

Rising Rate Environment: "Duration Timing with Style Premia"

We do not recommend attempts at trading the yield curve for most portfolios. As we've said elsewhere, if your mandate says you have to have bond exposure, buy a TIPS ETF or some 5-years.
However, with the boilerplate out of the way, these guys seem to have some interesting ideas.

From Flirting with Models:
This post is available as a PDF download here. 

  • In a rising rate environment, conventional wisdom says to shorten duration in bond portfolios.
  • Even as rates rise in general, the influence of central banks and expectations for inflation can create short term movements in the yield curve that can be exploited using systematic style premia.
  • Value, momentum, carry, and an explicit measure of the bond risk premium all produce strong absolute and risk-adjusted returns for timing duration.
  • Since these methods are reasonably diversified to each other, combining factors using either a mixed or integrated approach can mitigate short-term underperformance in any given factor leading to more robust duration timing.
In past research commentaries, we have demonstrated that the current level of interest rates is much more important than the future change in interest rates when it comes to long-term bond index returns[1].

That said, short-term changes in rates may present an opportunity for investors to enhance return or mitigate risk.  Specifically, by timing our duration exposure, we can try to increase duration during periods of falling rates and decrease duration during periods of rising rates.

In timing our duration exposure, we are effectively trying to time the bond risk premium (“BRP”).  The BRP is the expected extra return earned from holding longer-duration government bonds over shorter-term government bonds.

In theory, if investors are risk neutral, the return an investor receives from holding a current long-duration bond to maturity should be equivalent to the expected return of rolling 1-period bonds over the same horizon.  For example, if we buy a 10-year bond today, our return should be equal to the return we would expect from annually rolling 1-year bond positions over the next 10 years.
Risk averse investors will require a premium for the uncertainty associated with rolling over the short-term bonds at uncertain future interest rates.

In an effort to time the BRP, we explore the tried-and-true style premia: value, carry, and momentum.  We also seek to explicitly measure BRP and use it as a timing mechanism.

To test these methods, we will create long/short portfolios that trade a 10-year constant maturity U.S. Treasury index and a 3-month constant maturity U.S. Treasury index.  While we do not expect most investors to implement these strategies in a long/short fashion, a positive return in the strategy will imply successful duration timing.  Therefore, instead of implementing these strategies directly, we can use them to inform how much duration risk we should take (e.g. if a strategy is long a 10-year index and short a 3-month index, it implies a long-duration position and would inform us to extend duration risk within our long-only portfolio).  In evaluating these results as a potential overlay, the average profit, volatility, and Sharpe ratio can be thought of as alpha, tracking error, and information ratio, respectively.

As a general warning, we should be cognizant of the fact that we know long duration was the right trade to make over the last three decades.  As such, hindsight bias can play a big role in this sort of research, as we may be subtly biased towards approaches that are naturally long duration.  In effort to combat this effect, we will attempt to stick to standard academic measures of value, carry, and momentum within this space (see, for example, Ilmanen (1997)[2]). 

Timing with Value
Following the standard approach in most academic literature, we will use “real yield” as our proxy of bond valuation.  To estimate real yield, we will use the current 10-year rate minus a survey-based estimate for 10-year inflation (from the Philadelphia Federal Reserve’s Survey of Professional Forecasters)[3].

If the real yield is positive (negative), we will go long (short) the 10-year and short (long) the 3-month.  We will hold the portfolio for 1 year (using 12 overlapping portfolios).
It is worth noting that the value model has been predominately long duration for the first 25 years of the sample period.  While real yield may make an appropriate cross-sectional value measure, it’s applicability as a time-series value measure is questionable given the lack of trades made by this strategy....MORE