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Predicting Bonds with Stocks: A Strategy to Improve Timing in Corporate and High Yield Bonds

October 30, 2014

stocks and high yield bonds
Alpha Architect recently posted a good article summary of an academic paper that links the returns of corporate bonds to equity returns. The authors find that the equity market can lead corporate bond returns by up to one month. I have explored this concept before on the premise that there is a logical linkage between stocks and corporate bonds (and high yield) since they share vulnerability to common economic factors (growth, credit risk etc). Since stocks are far more liquid than corporate or high yield bonds, it makes sense that the stock market should have a leading signal.

As a simple test to demonstrate the potential value of this leading signal, one can compare a simple moving average strategy that uses the stock market to time either corporate or high yield bonds versus using the underlying market to generate the signal. The hypothesis would be that the stock or equity market signal should generate superior results to using a traditional moving average strategy using the underlying time series. Furthermore, we would hypothesize that the advantage should be superior relatively speaking for high yield bonds versus corporate bonds since they have more similar economic factor risk to equities (investment grade corporates are to some extent correlated to economic growth and credit risk, but also have greater interest rate sensitivity given the ratio of their credit spread to the total nominal yield). In addition, this effect is further enhanced by the fact that high yield bonds have lower liquidity than corporate bonds given that they tend to be issued by smaller/less diversified companies. This means that the lead/lag relationship between equities and high yield should be longer and more stable than for corporate bonds.

For our simple test, we use a 20-day moving average strategy to trade either High Yield (HYG) or Corporate Bonds (LQD) using either the underlying time series to generate signals or the S&P500 (SPY) to represent equity market signals. As with most SMA strategies, we go long if the close is above the SMA and in this case we allocate to cash (SHY) below the SMA. Here are the results extending the bond indices back to 1995:

stock predict bonds

Results are very much in line with both hypotheses: the equity market is a superior signal than using the underlying time series, and the advantage in applying this effect is stronger in high yield bonds versus using corporate bonds. The reduction in drawdown, and increase in risk-adjusted returns using the equity market signal to trade high yield bonds is substantial. As a note of caution, this analysis does not consider relative trading costs, but one would expect a similar number of total trading signals regardless of which market is used since they are exposed to similar risk factors and also use the same moving average lag. The lesson for quants is that it often helps to pay attention to the fundamental drivers of a market’s underlying return rather than applying naaive technical trading rules.

15 Comments leave one →
  1. steve permalink
    October 30, 2014 8:07 am

    David, I enjoyed the post. I was wondering what data you used to extend the high yield and corporate bonds back to 1995, and where I might find the data to do so. Many thanks.

    • david varadi permalink*
      November 2, 2014 1:09 pm

      hi steve, thank you. we used the morningstar corporate bond index to extend LQD and VWEHX– Vanguard High Yield Bond to extend HYG.
      best
      david

  2. October 31, 2014 2:26 pm

    This will make an interesting replica post with quantstrat to demonstrate pre-calculating off-instrument values. Also, the stepwise correlation FAA backtest is up on my blog now.

    • david varadi permalink*
      November 2, 2014 1:10 pm

      thanks Ilya, look forward to it.
      best
      david

  3. November 2, 2014 3:10 am

    This is one of the most interesting post from the perspective of the financial advisers’ clients, does the system trigger to often in a year to be followed by them?
    http://nightlypatterns.wordpress.com

    • david varadi permalink*
      November 2, 2014 1:11 pm

      hi aimdal, thank you–i think that this strategy could/should be modified to some extent for actual trading–the main purpose was to show the importance of looking at other markets.
      best
      david

  4. November 2, 2014 7:32 am

    Someone have any idea of how High Yield market works? How liquidity problems arise really when risk-off mode occur and you don’t need them? Anyone has ever tried to trade this market? Hope to be wrong but in my opinion backtest like this can work only on paper. I think that David should elaborate better this crucial point

    • david varadi permalink*
      November 2, 2014 1:14 pm

      hi tstudent, im no expert in the high yield market–just showing the relationship between equities and high yield. the strategy itself could/should use different trading vehicles or parameters to make it practical. liquidity and execution can be a factor and requires some expertise. however, it is not true that this type of test only works on paper–some adjustments to either the parameters or tradeables or both would be able to create a decent trading strategy. if your comment relates to individual high yield or corporate bonds rather than an index or fund, then i agree with you completely.
      best
      david

  5. November 2, 2014 3:40 pm

    Thank you David for your reply. Fund or ETF have individual corporates inside, so i think it’s the same thing. When the time arrive, when you more need liquidity, magically you see enormous bid\ask spread or sometime you could even see market maker disappear. It’s impossible to quantify this phenomenon. It’s exactly for this reason i said that every systematic attempt of this type (price time series based) could be just theorical. When you can’t quantify cost it’s very hard to make any conclusion. With sp500 future even in 2008 you could trade with just one tick of spread. The same is not true for HYG or similar.
    If i can ask, what do you mean for “some adjustments”?

    • david varadi permalink*
      November 4, 2014 12:59 pm

      tstudent, i agree that the pricing of these instruments is theoretical and in fact simply made up by the market makers and portfolio managers. however for a long time this has been a tradeable anomaly under certain conditions and using certain instruments (like mutual funds or derivatives etc). that said, i agree that given the size of the derivative markets and debt outstanding it is a riskier proposition than it has been in the past. its a question of whether or not you can get out before the liquidity problems actually kick in. of course no one has the answer to that. furthermore, much of the historical return was driven by high yields which are no longer available. perhaps ballpark estimate for the return of this strategy would be 5-8% going forward.
      again the purpose of the article was not to make conclusions or demonstrate a strategy that should be used for trading, but rather show that there are other drivers of performance for different markets and how to capture that in a trading strategy.

      best
      david

  6. sami permalink
    November 3, 2014 3:15 pm

    I want to make sure I got this right. You trade HYG using SPY 20 days SMA. Correct?

    • david varadi permalink*
      November 3, 2014 3:17 pm

      yes Sami, that is correct.
      best
      david

Trackbacks

  1. Thursday links: averaging in and out | Abnormal Returns
  2. The Whole Street’s Daily Wrap for 10/30/2014 | The Whole Street
  3. Predicting High Yield With SPY–A Two Part Post | QuantStrat TradeR

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