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1 November 2014 CFA Institute Journal Review

Low-Risk Anomalies in Global Fixed Income: Evidence from Major Broad Markets (Digest Summary)

  1. Butt Man-Kit, CFA

Empirical results show that lower-risk bonds generate positive alpha irrespective of the currency or market segment considered. The duration-times-yield (DTY) measure is a particularly efficient risk measure to screen bonds. Portfolios with the lowest DTY have the highest alphas and lowest volatilities as well as high Sharpe ratios.

What’s Inside?

The authors show that the low-risk anomalies in global fixed income can be observed in major broad markets. Investing in lower-risk bonds results in a higher Sharpe ratio. The results are extremely consistent and comparable for various types of bonds in different currencies.

How Is This Research Useful to Practitioners?

Modern portfolio theory suggests that the expected return of a portfolio can be predicted by the capital asset pricing model (CAPM). But the authors show empirical results that portfolios invested in lower-risk bonds have much higher risk-adjusted returns than those invested in higher-risk bond portfolios. In particular, the duration-times-yield (DTY) measure is an efficient risk measure to screen bonds and form portfolios exposed to the anomaly.

From a risk–return perspective, investing in lower-risk fixed income results in a higher Sharpe ratio. The conclusion is that including lower-risk fixed income in a strategic asset allocation portfolio will improve the overall risk-adjusted return.

The authors point out that the risk premium in the bond market in the coming years is expected to be much lower than the premiums seen during the back-testing period (1997–2012). If investors blindly seek higher returns with higher risk, they could expose the portfolio to very large risks and negative alpha. A lower remuneration of high-beta fixed income makes investing in low-risk fixed income with positive alpha and low beta more appealing.

To exploit the profit from the low-risk anomaly, the authors suggest that investors build their tracking error risk by investing in portfolios with levels of DTY that are somewhat less than the market’s but not too much less. The resulting portfolios will have beta that is slightly less than 1 and lower volatility than the market-capitalization index. In addition, the defensive portfolios should substantially outperform the market-capitalization index when the market index performs poorly. When the market performs well, the portfolio should generate similar levels of return to the market because the alpha from the lower-DTY bonds will compensate for the drag created from a beta of less than 1. The lower-DTY portfolios should also have higher Sharpe ratios than the market-capitalization index.

How Did the Authors Conduct This Research?

The data are extracted from the Global Index System from Bank of America Merrill Lynch. The authors use its historical index constituents starting with January 1997 and updating monthly until December 2012. They select the four most active currencies: USD, EUR, GBP, and JPY. The segments they consider include sovereign bonds, quasi and foreign government bonds, securitized and collateralized bonds, and investment-grade, high-yield, and emerging corporate bonds.

In each segment, the authors rank the bonds in the universe by a given risk measure, including DTY, modified duration, yield to maturity (YTM), duration times spread, and option-adjusted spread. The ranked bonds are formed into quintile portfolios, from the lowest risk quintile to the highest risk quintile. In each quintile, the bonds are weighted by their market value, and the portfolios are rebalanced at the end of each month to take into account changes in rankings. The authors measure the Sharpe ratio, volatility, alpha, and beta in each quintile portfolio.

They consider DTY to be the most efficient and consistent risk measure among the five risk metrics. DTY is the multiple of YTM and duration, so portfolios with lower DTY have investments in bonds with both lower spreads and shorter maturities. The empirical results show that, in general, the portfolios in the lowest DTY quintile generate the highest Sharpe ratio and highest alpha.

The authors test the robustness of the results by including market-timing effects and transaction costs as well as various currencies, industries, and ratings. The results are similar and highly consistent.

Abstractor’s Viewpoint

The authors propose a simple method to generate alpha in fixed-income investments. Despite it being true that lower-DTY bonds generate lower returns even with higher alpha, I do agree that a small amount of leverage, if built with low-leveraging costs, would allow investors to boost returns further.

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