Bond strategy delivers strong risk adjusted returns
A short dated crossover strategy in the bond market has shown promise in delivering strong performance and attractive risk-adjusted returns. This approach involves investing in the lower end of the investment grade universe, specifically BBBs, and the higher quality part of the HY market, namely BBs. The strategy’s effectiveness is attributed to the rolldown effect, which provides a decent level of income while minimizing exposure to longer-duration risks and lower-quality credit risks.
Back testing using 20+ years of index data has yielded compelling results, with the strategy demonstrating comparatively lower volatility and drawdowns than other fixed income asset classes. The maximum drawdown of 17% occurred during the global financial crisis, driven by the significant sell-off in credit spreads.
The crossover strategy achieves its outperformance by combining short dated BBB and BB indices, which broadens the opportunity set and increases diversification. The BBB and BB markets tend to have different sector concentrations, with BBB comprising mostly financials and BB consisting of utilities and telecommunications names. By bringing these two markets together, the strategy reduces reliance on individual sectors or issuers, creating a more diversified opportunity set.
Sceptics (including us!) will look for the hidden risks that could explain this outperformance. Sector/name concentration risk? No. BBB and BB markets tend to have very different sector concentrations. Short dated investment grade has a lot of financials, whereas high yield tends to have a lot of utilities and telecommunications names.
Downgrade risk? Unlikely. One might assume that bonds falling out of the IG universe and into HY would cause those bonds to underperform once the credit rating agencies downgrade them. This may be true in the very short term, but there is plenty of research out there showing that over the longer term ‘fallen angels’ outperform both IG & HY.
The strategy’s outperformance lies in its ability to offer an attractive level of income while avoiding excessive duration risk and lower-quality credit risk. History has shown that excessive credit risk can be particularly painful in periods of market stress, such as 2008, while excessive duration risk can materially impair returns when rates rise, as seen in 2022.
Using quantitative techniques to find an area of the bond markets that offers excess returns is pleasing enough. Discovering that those insights are borne out by historic data feels as though we’ve unearthed some buried treasure.
