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1 February 2013 CFA Institute Journal Review

Momentum in Government-Bond Markets (Digest Summary)

  1. Servaas Houben, CFA

Momentum strategies are not commonly used by fixed-income alpha investors. But the authors show that for liquid assets, such as government bonds, a momentum strategy may provide a good risk–return trade-off and a hedge for credit exposure.

What’s Inside?

Momentum strategies are commonly applied in equity, foreign exchange, and commodity markets, and they rely on delayed incorporation of new information by market players. But momentum strategies are not very common in fixed-income markets, in which yield movements are highly correlated between countries and depend on a limited number of factors, leaving less opportunity to execute this strategy. Nevertheless, the authors show that using a momentum strategy for (liquid) government bond markets results in extra return and additional diversification benefits. Thus, it can be an interesting strategy in combination with a credit portfolio.

How Is This Research Useful to Practitioners?

Currently, government bond momentum strategies are not widely used by practitioners. The widespread belief seems to be that because of transaction costs, margin requirements, and implementation time requirements, a theoretically correct strategy does not work well in practice. But widely traded government bonds do not suffer from these weaknesses.

Practitioners tend to believe that momentum strategies only work for certain periods of time (data mining) and not for other samples. But previous researchers showed that equity markets underreact to news and need to catch up, which allows momentum traders to profit from market inefficiencies or from taking on additional risk. A similar argument exists for government bond markets, although traders should take into account the additional complications of government intervention, such as quantitative easing.

Momentum strategies usually perform well in trending markets. Markets with either no clear direction or higher volatility are detrimental for momentum strategies. Momentum strategies perform better for large, liquid markets because the costs of frequent rebalancing will be limited. Thus, the momentum strategy works well for Germany, Japan, and the United States and not so well for Australia.

The authors show that there is a negative correlation between a credit fund and a government bond momentum fund, which could be a result of liquidity. Bear credit markets usually result in an increased demand for liquid assets, such as government bonds.

The diversification benefits hypothesis is tested by combining a corporate bond fund with a government bond momentum strategy. The authors show that shocks in credit funds are absorbed by the momentum strategy, and hence, there is an opportunity to exploit interest rate trends.

How Did the Authors Conduct This Research?

The authors use a dataset from February 1987 to September 2011 that consists of six major government bond markets and the one-month LIBOR index. They then divide the sample period in half because the later years of the sample have seen more yield volatility than the earlier years. The division also allows the authors to see whether the results are dependent on sample choice. The monthly excess return is defined as the difference between the government bond return and LIBOR. The authors apply a monthly momentum strategy that goes long when the previous month’s excess return is positive and goes short when the return is negative.

The authors group the government bond indices into an overall broad index (including Canada and Australia) and a “major four” index (the United Kingdom, the United States, Japan, and Germany) because the latter has a more liquid government bond market. They then define different term buckets to assess whether a momentum strategy is more effective for certain maturities. For each of the groups, they calculate the excess return, volatility, and resulting information ratio.

For both samples, a positive information ratio exists for the largest markets, indicating that a momentum strategy can work well under different market conditions. Also, funds with five-year to seven-year terms perform best compared with funds with other maturities because they are the most responsive to the economic cycle. Long-maturity bonds tend to be more stable because of steady demand from pension funds and insurance companies and are thus less suitable for momentum strategies.

Abstractor’s Viewpoint

The paper shows that government bonds can be actively managed instead of simply being used as a risk-free asset. The authors show the efficiency of a momentum strategy for the past 25 years and derive conclusions from their analysis. One issue that leaves the reader wondering is the outperformance of a bond fund and momentum strategy compared with that of the pure bond fund. Is there a relationship with general diversification benefits that would also arise with other asset classes or with specific diversification benefits between a credit fund and a momentum strategy? Nevertheless, the authors make a clear case that more fixed-income (credit) managers should consider including a momentum strategy in their portfolio mixes.

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