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The fixed income securities market - an overlooked giant?

Stefan Sluke, Portfolio Manager

Man Systematic Strategies

Q4 2013

 

The world equity and world bond markets are of a comparable size1. However, the amount of attention that opportunities in these markets receive is remarkably different:

  1. journalists focus their attention on equity rather than on fixed income markets (see Exhibit 1);
  2. academic publications mainly study equity market phenomena (see Exhibit 2);
  3. there are many more equity hedge funds than fixed income oriented hedge funds2.

Exhibit 1: Number of articles published by Thomson Reuters

 

01 Reuters.jpg

Source for underlying data: Thomson Reuters News Analytics. Numbers computed by Man. Articles on companies have been counted as equity related unless there was at least one fixed income related key word assigned to them.

 

Exhibit 2: Number of papers published on SSRN

 

02 SSRN.jpg

Source: Numbers computed by Man based on SSRN web search results. 

 

Why do opportunities in fixed income markets receive so little attention? One answer could be that fixed income markets exhibit limited opportunities. However, one may also argue the converse: the lack of fixed income research could imply some untapped opportunities.

There are arguments for both points of view: On the one hand, fixed income may indeed exhibit fewer opportunities.

For equity markets, there exists a large universe of stocks and for each stock there is a wealth of publicly available fundamental information – creating plenty of room for disagreement and misevaluation. While a similar amount of information is available for corporate bonds, their liquidity tends to be limited, making it hard to capitalise on opportunities.

Government bonds are liquid, but are subject to only a very limited amount of instrument-specific information – creating little room for disagreement and misevaluation.

On the other hand, the lack of attention to fixed income markets may imply that there are untapped opportunities. In fact, recent research by McLean and Pontiff has found that opportunities decay as they get publicised in the academic literature3.

The authors’ choice of which anomalies to analyse is interesting: they study 82 anomalies – 82 anomalies related to equity markets and zero anomalies related to fixed income markets!

In this paper, we try to gauge the number of opportunities in fixed income markets by analysing how different alternative fixed income strategies would have performed historically, and how this compares to alternative equity strategies.

Our starting point for selecting strategies is the observation that strategies can be grouped according to two criteria, namely whether a strategy predicts:

  1. the absolute direction of a market, or the relative direction between two or more markets;
  2. asset prices to trend, or asset prices to revert (to a ”fair value”).

This classification leads to the following four strategy types:

 

  Value Momentum

Non-

directional

Buy relatively cheaper while selling relatively more expensive securities

Buy previously out­performing while selling previously under­performing securities
Directional Buy when historically cheap, sell when historically expensive Buy after positive performance, sell after negative performance

 

For each type, we will present (reasonably simple) strategies for fixed income and equity markets. We begin with value strategies and then turn to the momentum strategies.

 

Value strategies

Non-directional value strategy – buy relatively cheaper while selling relatively more expensive securities

For equity markets, non-directional or “cross-sectional” value strategies are well documented in academic literature and commonly pursued by fund managers. The basic idea is to buy (or overweight) stocks that are cheap and to sell (or underweight) stocks that are expensive. Common value metrics are variants of the price-earnings or price-to-book ratios.

An analogue in fixed income markets would involve buying bonds from countries with high yields and selling bonds from countries with low yields. While fixed income strategies built along these lines can yield positive returns, they are susceptible to severe drawdowns as yield spreads tend to sharply widen from time to time. Such increases in yield spreads tend to affect multiple countries at the same time, making it difficult to diversify away this risk (a recent example was the selloff of peripheral European bonds in 2011/12).

Another notion of value in fixed income markets is to trade different points of a yield curve against each other, i.e. to go long points of the yield curve that are “cheap” and short points of the yield curve that are “expensive”. For example, a well established strategy is to trade the five year point against the two and 10 year point, which is schematically illustrated in Exhibit 3.  

 

Exhibit 3: Schematic illustration of trading a yield curve

 

3 yield curve 2.jpg

Source: Man.

 

The rationale behind this “2/5/10 butterfly trade” lies in the fact that the two and 10 year points typically move in a certain relation to the five year point. For instance, if the five year point moves out of line following the issuance of new bonds, then it tends to revert back over time. Also, the carry dynamics (in the form of yield and roll-down) of the two, five and 10 year points can provide an additional source of income. This trade has no direct analogue in equity markets.

Below is a simple example of a curve trading strategy for the US and the German government bond yield curves (details on the implementation can be found in the appendix). For these two countries, there exist two, five and 10 year government bond futures, which makes implementing a 2/5/10 butterfly trade particularly easy. The strategy could be extended to other yield curves, for instance by trading interest rate swaps rather than government bond futures. Exhibit 4 shows the simulated annual returns of the strategy. The Sharpe ratio for the strategy is 0.57 net of estimated transaction costs; the correlation to a passive strategy (that is always long the five year points) is 0.22, i.e. relatively low.

 

Exhibit 4: Simulated returns of a simple curve trading strategy

 

04 curve trading.jpg

Returns have been scaled to an annualised volatility level of 10%. Source: Man.

 

So it is possible to follow a value strategy in fixed income markets as well as equity markets. However, there are differences. In equity markets, there is a large universe of stocks and each stock has a large amount of fundamental information. Ultimately, a value strategy in equity markets aims to capitalise on misevaluations of this fundamental information. In contrast, the universe of countries with liquid government bonds and the amount of bond specific information is limited. However, our value strategy is able to use technical data to capitalise on transient distortions in yield curves, for instance caused by central bank action or issuance activity.

 

Directional value strategy – buy when historically cheap, sell when historically expensive

While also a value strategy, a directional interpretation of value has a rather different proposition than its non-directional counterpart: it reflects the view that it is possible to time the purchase and sale of an asset, i.e. to buy equities or bonds when they are cheap and to sell equities or bonds when they are expensive. This idea is frequently expressed in the media; in fact discussions addressing whether it is the “right time” to get in or out of the stock or bond markets appear to be ubiquitous.

However, in our experience it is difficult to design (reasonably simple) strategies that would have generated positive returns by timing equity or fixed income markets based on value measures. More specifically, the challenges in designing such a strategy are twofold: First, going short is costly in both bond or equity markets as stocks and bonds generate positive income in the form of company earnings or coupon payments. Thus, even if valuations of overpriced assets revert eventually, the negative income in the meantime may well overwhelm the total returns. Second, it is easy to make statements about what level of value is “cheap” or “expensive” looking back at historical data. However, in real time, determining value is much more challenging4.

To illustrate the difficulty that one faces in building a profitable strategy, Exhibit 5 shows long-term time series computed by US economist Robert Shiller of price-earnings ratios and interest rates in the US. Equities looked expensive from the mid 1980s to 2000 compared to the historical average; yet equity markets rallied strongly over this period, causing a severe drawdown in the strategies we tested. For long-term interest rates, the challenge arises from the fact there was effectively only one cycle: interest rates went up until 1982 and then declined.

 

Exhibit 5: Price-earnings ratio and long-term interest rates

05 PE 600.jpg

Data for the US as computed by Robert Shiller.
Source: Robert Shiller’s website.

 

In summary, it has not been easy to generate returns by timing investments based on fundamental measures of value – in either fixed income or equity markets.

 

Appendix

Implementation of the 2-5-10 curve trading strategy

 

The curvature of a yield curve is measured as:

(5 year government bond rate)
- ½ * (2 year government bond rate)
- ½ * (10 year government bond rate)

The strategy takes positions in the two, five and 10 year point. Specifically, the position in the five year point is hedged with positions in the two and 10 year point, each of them having half of the opposite risk exposure of the five year point. In the five year point, the strategy goes long (short) a constant amount if µC + Carry is positive (negative), where  

  • µ is the mean reversion speed (set to 1.0%),
  • C is the curvature of a yield curve minus its average value over the last five years,
  • Carry is the carry income from holding a long position in the five year point that is hedged with positions in the two and 10 year point.

The bid-offer spread has been assumed to be one tick wide for both German and US bond futures. The returns from trading the two curves have been equally weighted in terms of their volatility contribution.

 

Part 2 of this article, which analyses momentum strategies, will be published in the next edition of the AIMA Journal.

 


 

Footnotes

[1] The market capitalisation of the Bloomberg World Exchange Market Capitalisation index (WCAUWRLD) was USD 55 trillion and the market value of the Barclays Capital Aggregate Bond index was USD 42 trillion (as of 20 March 2013).

[2] There are 1,027 equity and 204 fixed income (including credit) hedge funds reporting to the HFR database (as of April 2013).

[3] McLean, R. David and Pontiff, Jeffrey. 2013. “Does Academic Research Destroy Stock Return Predictability?”, working paper.

[4] For academic research on the difficulty to predict stock market returns with value measures, see: Goyal, Amit and Welch, Ivo. 2008. “A Comprehensive Look at the Empirical Performance of Equity Premium Prediction”, Review of Financial Studies, 21(4), 1455-1508.

 

Important information

This material is communicated by Man Investments Limited (the ‘Company’), a member of Man Group plc ('Man'). The Company is authorised and regulated by the Financial Conduct Authority in the UK.

Hong Kong: To the extent this material is distributed in Hong Kong, this material is communicated by Man Investments (Hong Kong) Limited (the ‘Company’) and has not been reviewed by the Securities and Futures Commission in Hong Kong. This material can only be communicated to intermediaries, and professional clients who are within one of the professional investor exemptions contained in the Securities and Futures Ordinance and must not be relied upon by any other persons.

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Australia: To the extent this material is distributed in Australia it is communicated by Man Investments Australia Limited, which is regulated by the Australian Securities & Investments Commission (ASIC).

This material is for informational purposes only and does not constitute any investment advice or research of any kind. Opinions expressed are those of the author and may not be shared by all personnel of Man. These opinions are subject to change without notice. This material is for information purposes only and does not constitute an offer or invitation to make an investment in any financial instrument or in any product to which any member of Man’s group of companies provides investment advisory or any other services. Any organisations, financial instruments or products described in this material are mentioned for reference purposes only and therefore, this material should not be construed as a commentary on the merits thereof or a recommendation for purchase or sale. Neither Man nor the author(s) shall be liable to any person for any action taken on the basis of the information provided. Any products and/or product categories mentioned may not be available in your jurisdiction or may significantly differ from what is available in your jurisdiction. Some statements contained in this material concerning goals, strategies, outlook or other non-historical matters may be forward-looking statements and are based on current indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and Man undertakes no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. The Company and/or its affiliates may or may not have a position in any security mentioned herein and may or may not be actively trading in any such securities. Past performance is not indicative of future results. This material is proprietary information of the Company and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from the Company. The Company believes its data and text services to be reliable, but accuracy is not warranted or guaranteed. We do not assume any liability in the case of incorrectly reported or incomplete information. Information contained herein is provided from the Man database except where otherwise stated.

Past performance may not necessarily be repeated and is no guarantee or projection of future results. The value of investments and the income derived from those investments can go down as well as up. Future returns are not guaranteed and a loss of principal may occur.

Please note that all information in this document is furnished as of the date stated on the cover of this presentation, unless otherwise stated.  This document and its contents are confidential and do not carry any right of publication or disclosure to any other party. All rights reserved, Man (2013).

 

 

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