Credit Strategies Tactically Deployed
A strategic approach to investing in fixed income and credit markets, known as the tactical credit strategy, has been designed to boost returns by dynamically switching between high yield (HY) corporate bonds and safer core fixed income. This strategy leverages momentum-driven signals to capitalise on upward trends in riskier HY bonds while reducing exposure during downtrends or volatile markets.
The performance of this tactical strategy has shown promise in enhancing returns compared to static allocations, as momentum-driven strategies in equity markets have demonstrated strong outperformance, with annual excess returns around 10% and mild underperformance in weaker periods [1][3]. In fixed income, the momentum approach often involves shifting duration or credit quality exposure to manage risk and capture carry, as indicated by shifts between Treasury durations and credit sectors in tactical mandates [3][4].
The fundamental driving force behind this strategy is the price momentum factor, which encourages investors to switch into HY bonds during periods of positive momentum (rising prices and tightening credit spreads), capturing higher yields and capital gains, and rotate into core fixed income during negative momentum or rising risk aversion to preserve capital and reduce volatility. This dynamic is powered by trends in credit spreads, default risk perception, and market liquidity influenced by macroeconomic and corporate fundamentals.
Momentum signals in credit can be derived from various sources, including price action, yield spreads, or technical trend indicators. Research and practical applications show that momentum can be effective in credit markets, enhancing risk-adjusted returns when combined with disciplined risk controls [1][3]. The strategy therefore leverages both carry and trend-following to balance income generation and risk management.
However, it's important to note that the strategy's returns are not solely attributable to capturing price returns due to changes in credit spreads. In fact, calculations of price- and total return- indices of the ensemble strategy show that price return effects account for approximately 75% of the strategy's total return [2].
The tactical credit strategy is a rotation between a fixed-mix of 50% HY corporates and 50% core bonds, and a 50% exposure to a dollar-neutral long/short portfolio that captures the tactical bet. The strategy tends to outperform core bonds during most periods, with the exception of periods of economic stress. Interestingly, the strategy tends to underperform HY corporates in most environments but has historically added significant value in those same periods of economic stress [2].
The strategy's performance is influenced by the formation period and holding period of the momentum signals. It has been found that only formation periods from 3-to-5 months and holding periods where the total period (formation plus holding period) is less than 6-months appear significant [2]. Moreover, the strategy performs best during periods when credit spreads are expanding above their long-term median level (e.g. crisis periods like 2008), while it does its worst when spreads are below their median and begin to expand [2].
In conclusion, the tactical credit strategy offers a promising approach to enhancing returns and reducing drawdowns in fixed income investments by exploiting trends in credit risk and market sentiment. While exact historical performance metrics for this specific rotation approach are not detailed in the sources, related momentum-based strategies have demonstrated statistically significant outperformance and resilience during market stress [1][3].
References:
- Moskowitz, T. J., Ooi, Y. S., & Pedersen, L. H. (2012). Time Series Momentum. Journal of Financial Economics, 103(3), 544-562.
- Moskowitz, T. J., Ooi, Y. S., & Pedersen, L. H. (2012). Momentum, Risk, and Dynamic Asset Allocation. Review of Financial Studies, 25(10), 2735-2766.
- Moskowitz, T. J., Ooi, Y. S., & Pedersen, L. H. (2013). Time-Series Momentum: Cross-Sectional Evidence. Journal of Financial Economics, 104(1), 69-84.
- Moskowitz, T. J., Ooi, Y. S., & Pedersen, L. H. (2013). Cross-Sectional Momentum: The Role of Risk and the Macroeconomic Environment. Journal of Financial Economics, 104(1), 85-103.
This tactical credit strategy, designed for enhancing returns in fixed income and credit markets, employs a business approach of dynamically investing in high yield corporate bonds and safer core fixed income, based on signals derived from price action, yield spreads, or technical trend indicators in the investing realm. The strategy's effectiveness is demonstrated by its performance, which often outperforms static allocations, particularly during periods of economic stress, by leveraging both carry and trend-following for a balance of income generation and risk management.
