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The Variable Credit Approach to Fixed Income Investing

September 11, 2012 - 0 comments

With government bond yields near record lows, investors have been looking to corporate bonds to make up some of the shortfall.  As credit spreads (the difference between corporate bond yields and government bond yields) hover at around 150 basis points, I can’t blame yield-starved investors for wanting to make the switch.

Source:   Bank of America Merrill Lynch Global Index System

The strategy of increasing a portfolio’s exposure to corporate bonds when spreads are wide (and vice-versa) is called the variable credit approach to fixed income.  Without trying to sound like a fortune-teller (or worse yet, an active bond manager), research does appear to suggest that there has historically been a reliable relationship between current credit spreads and future return differences.  In other words, if most investors are fearful, it might be the right time to be a bit greedy.  

If we run a regression analysis using Canadian credit spreads at the end of the year as the independent variable and the annual return difference between corporate and government bonds in the following year as the dependent variable, we can determine if a reliable relationship exists between current credit spreads and future return differences.

Regression Results
If you thought you’d be able to get through one of my blogs without having to sit through another boring regression analysis, think again.  To make things less painful, however, I’ve included only a few of the main points below:

  • Current differences in credit spreads explain 39% of the variability in future returns differences between Canadian corporate and government bonds.
  • Results are economically important (large slope coefficient of 4.26).
  • Results are statistically reliable (T-Stat of 3.16…anything above 2.00 indicates a reliable result)

Source:    Bank of America Merrill Lynch Global Index System
               Yields:  1996-2010; Returns:  1997-2011

Simulating a Variable Credit Strategy using Canadian Data
Now I know performance junkies are jonesing for a back-test of this strategy, so here it is:

  • Monthly returns from the BofA Merrill Lynch Canadian Corporate and Government Indices are used.
  • The benchmark portfolio is 30% corporate bonds and 70% government bonds.
  •  Corporate bonds cannot be over or under-weighted by more than 20% relative to the benchmark portfolio.
  • The allocation to corporate bonds for any given year is based on the credit spread on December 31st of the prior year (i.e. if the spread on December 31st, 2010 was 1.37%, the allocation to corporate bonds in 2011 would be 35%).
  • The corporate bond mix is revisited at the end of each year and adjusted accordingly (based on the rules below).

Arbitrary Rules:

Source:   Bank of America Merrill Lynch Global Index System

Simulation Results
Although the results do not seem to be impressive, realize that the intention of the variable credit strategy is not to knock the ball out of the park.  It is a disciplined, rules-based tilt towards the credit factor only when the risk is reasonably expected to be compensated for.  As you can also see, the variable credit simulation had a higher return, similar standard deviation, as well as a higher average allocation to government bonds over the period studied, relative to the benchmark. 

Sources:  Dimensional Returns 2.0, Bank of America Merrill Lynch Global Index System

Although a low-cost, passively managed bond portfolio is arguably one of the best choices for individual investors, a variable credit strategy may prove to add-value in an already low-interest rate environment.

By: Justin Bender with 0 comments.
Filed under: DFA, Fixed Income, Strategy
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