Bond timing

There are two types of active fixed income management strategies. The first relies on optimal weighting of portfolio across assets and is thus similar to stock picking. The second is about when to buy and when to sell a given asset, relying on timing sills. Bond timing strategy profits from buying and selling fixed income securities rather than more traditional buy and hold strategy that relies on coupons. Profit is realized from favourable price changes of a bond on the secondary market. Price change is an inverse function of an interest rate change. By timing bond purchases, investor can capitalize on his interest prediction skills. In addition to changes in interest rate, another significant factor impacting bond prices is credit risk. Investor here can try to time the changes in credit spreads that depend on credit worthiness of corporations, risk-on and risk-off global effects or flows in and out of emerging markets. Temporal change in credit spreads is often brought about by changes in the wider economic factors such as GDP growth, political stability, fiscal discipline and inflation. Therefore credit timing is more similar to stock market timing. Majority of bond timing strategies however focus on forecasting the evolution of interest rates, examples of which are such Roll Down, momentum, carry and sector switching.

Roll Down is a popular fixed income strategy used by active managers that profits from high loading on duration and maintaining it by replacing maturing bonds. This way portfolio keeps high duration that profits from grater bond yields for long maturity bonds. The steeper the yield curve the higher the roll down profits as market usually rewards holding long maturity bonds more than short. This way bond price increase due to decrease in discount rates as time passes. As a bond moves closer to the maturity its risk decreases and price increases. Capturing the price increase at points where it is most prevalent is the key to earning the high term spread premium. This strategy however carries a risk from monetary policy changes and is highly dependent on interest rate cycles.

The persistence in interest rate policy gives rise to an economic cycle based approach to bond timing that tries to identify the cycle inflection points. Here investor relies on momentum effect created by slow-moving or permanent economic variables, and tries to predict (or avoid) monetary policy shifts. Taylor (1998) finds that bond investment returns are mostly dependent on the direction of the short term return however these in turn depend on the economic cycles. Using spread-trading strategies that trigger reallocations using turning points in the cycles, Boyd and Mercer (2010) demonstrate that straightforward allocation rules lead to superior risk-adjusted performance relative to standard fixed-income benchmarks.

Researchers and practitioners on average see fixed income active management to be justified by its excess returns and superiority to actively managed equity. This is due to lower number of moving parts and more stable risk premia. According to Jamil Baz (2017) at PIMCO the majority of active bond funds and ETFs beat their median passive peers after fees over the past 1, 3, 5, 7 and 10 years, with 63% outperforming over the past 5 years. In contrast, the majority of active equity strategies failed to beat their median passive counterparts during the period. Only 43% outperformed over the past 5 years; in every other period, the percentage is lower still.

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The Encyclopedia of Quantitative Trading Strategies

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