Note: This article appears on the ETFtrends.com Strategist Channel
By Gary Stringer, Kim Escue and Chad Keller
Stringer Asset Management is risk-aware when looking at the fixed income market due to the asymmetrical returns associated with the asset class. The risk of loss from the asset class can be larger than the potential upside. Therefore, we place an emphasis on the relative risk we are taking on to achieve excess returns, rather than focus solely on the excess return over the risk-free rate.
Some fixed income risk factors are fairly straight forward. For example, interest rate risk as measured by duration is relatively easy to value. In the absence of options (e.g. calls, puts, sinking funds), the longer the maturity of a bond, the longer the duration. In a normal environment investors receive a premium over the risk-free rate as they move out the yield curve and take on more uncertainty with respect to inflation and other factors.
As market conditions change, we experience different movements across the yield curve and generally we can quantify how these yield curve shifts will impact our most basic Treasury holdings. As we layer on additional risk factors, such as credit risk and options, we can estimate a value for them based on historical spreads and performance to determine if we are getting paid fairly for assuming those risks.
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The starting point for our modeling is the Treasury market and, in particular, the 3-Month Treasury Bill. In a normal environment with a positively sloped yield curve, an investor receives an incrementally higher premium for the longer the maturity of a bond. Longer bonds normally have a higher premium because they are impacted to a greater degree by inflation risk and supply and demand, which can cause rates to move. Also, longer duration bonds experience deeper price declines when rates rise. Therefore, we emphasize short to intermediate bonds as they tend to provide a more consistent premium on a risk-adjusted basis when considering standard deviation and downside risk (the following charts compare the Sharpe Ratio, a measure of risk-adjusted returns, and other risk measures for different maturity U.S. Treasury bonds). On average, we think the intermediate are of the curve offers the best risk-adjusted value.
Additionally, we favor investment-grade credit in our strategic fixed income allocations, which exposes a portfolio to corporate risks, such as credit rating changes. Taking on investment-grade credit risk provides a yield advantage and the potential for upside with still enough rate sensitivity to help offset equity risk.
We tend to first favor investment-grade bonds over high yield as strategic holdings. High yield bonds are more likely to be impacted by actual defaults, higher liquidity premiums, and tend to be more equity sensitive (see the correlation to the global equity MSCI ACWI Index graph). Our philosophy with respect to a core fixed income allocation is that the holdings should help mitigate equity risk, so taking on additional equity sensitivity in the fixed income allocation makes little sense.
In addition to interest rate risk and credit risk, we implement a long-term allocation to mortgage-backed securities. These bonds tend to compensate investors for the call option risk they include. Option risks include the prepayment of principal by homeowners due to unplanned events, such as a mortgages being paid off early or the sale of a home. Investors are also compensated for extension risk as interest rates rise and the pre-payment option becomes less attractive, resulting in an extending duration. In general, bonds structured with call options protect better to the downside due to the price compression they experience when interest rates fall. Over time, they tend to provide attractive risk-adjusted results in our opinion.
The table below shows that, over various time periods, exposure to option risk, as represented by the Citigroup Collateralized Index, tends to offer the largest risk-adjusted excess return relative to the risk-free rate, followed by investment-grade credit, and Treasuries. High Yield bonds and longer-dated Treasuries, trail over longer holding periods due to their potential volatility, thus making them unattractive strategic holdings in our view. When investing for total return, we save these investments for our tactical allocations.
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Finally, we realize that the bond market changes over time and the risk and potential rewards of this market also change. Therefore, we take a dynamic approach with our allocations through strategic shifts and look to add value tactically through identifying momentum and value opportunities that arise. For example, high yield and longer duration Treasury bonds make sense tactically and can add value as momentum builds in favor of different risks over shorter periods. Additionally, particular sectors of the bond market may become attractive on a relative value basis due to attractive yields on a historical basis or relative to other sectors.
In summary, we tend to emphasize an intermediate duration with a heavy weight to investment grade corporate bonds, and mortgage-backed bonds within our strategic fixed income allocation. Tactically, we will look to areas that we believe offer shorter-term opportunities, such as high yield, longer-duration bonds, and specific sectors.
Gary Stringer is the CIO, Kim Escue is a Senior Portfolio Manager, and Chad Keller is the COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
[related_stories]DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
Data is provided by various sources and prepared by Stringer Asset Management LLC and has not been verified or audited by an independent accountant.
INDEX DEFINITIONS
The Citigroup 30-Year Treasury Benchmark is designed to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than 30-years. The Citigroup 10-Year Treasury Benchmark is designed to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities of approximately 10-years. The Citigroup 5-Year Treasury Benchmark is designed to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities of approximately 5-years. The Citigroup 2-Year Treasury Benchmark is designed to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities of approximately 2-years. The BofA Merrill Lynch 3-5 Year U.S. Treasury Index is designed to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities of approximately 3 to 5-years. The Barclays Municipal Bond Index is designed to track the U.S. long-term tax-exempt bond market, including state and local general obligation bonds, revenue bonds, pre-refunded bonds, and insured bonds. The Barclays U.S. Intermediate Credit Index is designed to track U.S. dollar-denominated, investment-grade corporate, sovereign, supranational, local authority and non-U.S. agency bonds with remaining maturities between 1 and 10 years. The Barclays Intermediate U.S. High Yield Index is designed to measure the performance of publicly issued U.S. dollar denominated high yield corporate bonds. High yield securities are generally rated below investment grade and are commonly referred to as “junk bonds.” The Citigroup USBIG Credit Index is designed to track U.S. corporate securities with a minimum of 1-year remaining maturity. The Citigroup USBIG Collateralized Index is designed to track U.S. collateralized debt securities with a minimum of 1-year remaining maturity. The Citigroup USBIG Treasury Index is designed to track U.S. Treasury debt securities with a minimum of 1-year remaining maturity. The Barclays High Yield Corporate Index covers the universe of fixed rate, non-investment grade debt. Pay-in-kind (PIK) bonds, Eurobonds, and debt issues from countries designated as emerging markets are excluded, but Canadian and global bonds (SEC registered) of issuers in non-emerging market countries are included. Original issue zero coupon bonds, step-up coupon structures, and 144-As are also included. The MSCI ACWI (Net) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI Index consists of 23 developed and 23 emerging market country indexes. Net total return includes the reinvestment of dividends after the deduction of withholding taxes, using a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties. The Barclays U.S. Aggregate Bond Index provides a measure of the U.S. investment grade bond market, which includes investment grade U.S. Government bonds, investment grade corporate bonds, mortgage pass-through securities and asset-backed securities that are publicly offered for sale in the United States. The securities in the Index must have at least 1 year remaining to maturity. In addition, the securities must be denominated in US dollars and must be fixed rate, nonconvertible and taxable.