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Tuesday, January 15, 2013

Beat the Bond Market

Beating any market is not easy.  Philosophically, I'm of the school that markets are basically efficient, meaning that at any point in time buyers and sellers offset themselves to the extent that the market fully reflects available information including expectations.  If they didn't, then shrewd traders would be able to exploit situations on a persistent basis.  I haven't seen convincing evidence that more than a very few investors may be able to do this with any consistency and more than enough evidence that many take a severe beating trying.

I see you are still here; so, with that off my chest, let's think about beating what many people would argue (and, by the way, have been arguing for some time) is the most mis-valued market today - the bond market.

Barclay's Aggregate Index

The first step is to define the market we're trying to beat and, for most fixed income investors, that would be the Barclay's Aggregate Index.  For those not familiar with the index, it is to the bond market what the S&P 500 is to the stock market.  Ask a large cap stock manager about performance, and he or she will typically give you a comparison versus the S&P 500.  Similarly, a professional bond manager will give you a comparison versus the Barclay's Aggregate.

The second step, then, is to understand the Barclay's Aggregate Index.  To grasp the importance here, let's recall that we are talking about a major portion of most investor's assets.  For example, a 40-year-old may have an allocation of 60% stocks/40% bonds and cash.  Thus, outperforming the bond market adds meaningfully to the bottom line.

The Aggregate Index is essentially the taxable investment grade U.S. bond market with a maturity greater than 1 year.

The two most important things to know about the index is its sector composition and its duration.  In terms of sector composition, consider U.S. Treasuries.  This is a sector that has been growing as the Federal Government finances its chronic deficits and now comprises more than 35% of the index.  U.S. Treasuries happen to be the safest and most liquid taxable fixed income instrument in the world.  As such, they have the lowest yields.  So right off the bat, a major change to a fixed income position would be to hold a larger or smaller position in Treasuries.  This would be balanced by holding an offsetting position in the other sectors.

Duration, the second important thing to know, measures the approximate price responsiveness for a given change in interest rates.  The duration of the Aggregate Index is approximately 4.4 years.  It tells you that, if yields rise 1%, then the price of the index will drop 4.4% and vice versa.  Thinking about this, you realize that prices will drop more if duration is higher and yields rise than otherwise.

Today, the consensus seems to be that yields will rise (after all, they are at historical lows and the Fed is aggressively expanding the monetary base); and, therefore, the aspiring bond market beater would want to have less duration than the Aggregate Index.

So here is the composition of the Index in terms of AGG, the exchange traded fund that tracks the Index:

Source: Blackrock
CLICK IMAGE TO ENLARGE Composition-wise then, any difference in the weightings will be a different portfolio and hence a different performance.  In other words, varying the sector composition is a way to express your bets.  An example of a way to do this would be to put 75% of the bond portion of your assets in the AGG exchange traded fund and then 25% in CSJ or LQD.  These are exchange traded funds comprised of corporate bonds.  CSJ has the shorter duration.

Investing Outside the Index

Another, more aggressive, approach investors use is to go outside the index.  There is a lot of this going on today.  An example would be to invest 10% of the bond allocation in JNK or EMB.  JNK is an exchange traded fund indexed to a high yield or "junk bond" index.  EMB is an exchange traded fund indexed to emerging markets bonds (i.e., China, India, etc.).  Both of these are outside the Barclay's Aggregate Index.  And both increase credit risk and, therefore, should be used judiciously.

As you can readily see, the possibilities are endless in terms of structuring your bets relative to the Barclay's Aggregate Index.

But what about duration?  The moves just mentioned will change duration, and they should be monitored.  An easier approach, if you want to stick with the sectors in the Aggregate Index but lower the duration (because, again, you think yields will rise), would be to increase cash.  This obviously will lower duration.

Monitor versus the Aggregate

Finally, you may want to monitor whether or not your market-beating attempt is playing out.  Here is a sample  portfolio:





%
YLD.
DUR.
EXP.
(P) 12/31
HYS
15487
0.049
3.71
1.77
0.55
103.43
BKLN
4988
0.016
4.8
0
0.76
24.98
SCHZ
18587
0.058
1.3
4.47
0.05
52.34
VCIT
105672
0.331
2.54
6.31
0.12
87.66
CSJ
87531
0.275
0.72
1.84
0.2
105.48
MBB
41043
0.129
2.53
1.37
0.26
107.99
FLOT
10122
0.032
1.02
0.14
0.2
50.59
HYG
35378
0.111
5.31
4.01
0.5
93.35

318808
1.000




PORT.


2.32
3.57









AGG


1.61
4.4
0.08
111.08


Note that the portfolio has a duration lower than the index at 3.57 years versus 4.4 years for the Index and has a bit higher of a yield.  To monitor, all I have to do is collect prices (from Morningstar or Yahoo! Finance) and weight using the weights under the "%" column.  I also put in the expenses of each fund because I like to keep them in front of me.

After 6 months or so, you'll be able to tell if you are a bond market guru.  To get a bit accurate, add in the yield differential.  In fact, you may want to compare to active bond mutual fund managers.

As an aside, if you are interested in the bond market but haven't explored it much, it would be a good exercise to check out the exchange traded funds listed, as they will give you an idea of what is out there.

Good luck!

Disclosure:  This post is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.  I and my clients own the exchange traded funds mentioned.


7 comments:

  1. You might be able to adjust your asset allocation to different classes of bonds to try to beat the index, but you would also be increasing risk and volatility. If bonds are meant to be the stable anchor to your portfolio, you might be better advised to change the asset allocation mix on the stock side of the portfolio and try to beat the S&P 500.

    ReplyDelete
    Replies
    1. My feeling is that sometime in the next 5 years the bond bubble will burst and therefore positioning to out perform the bond market is the easier task. Bonds in the past have been the stable part of portfolios because interest rates have been pretty much stable or declining. If rates rise sharply all that goes out the window.
      Beating the S&P 500 over the next several years is to me the much greater challenge. I think we may be in the same place today with interest rates where we were with P/E ratios in the late 90s.

      Delete
    2. I agree it is inevitable that the bond bubble will burst (just don't know when) which is why I'm in short and intermediate term bonds, no long-term exposure. Junk will get hurt just as bad if not harder than investment grade bonds.

      Delete
    3. You might be right. On the other hand I see the possibility of rates rising sharply as the economy picks up and inflation picks up in which case junk and corporates in general may hold spread.
      As time goes by and spread holds in non Treasury issues give up a lot of performance!
      When it comes to junk I worry mostly about historical spreads and recessions.
      As a compromise I use HYS - a low duration junk ETF.

      Delete
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