FolioBeyond Fixed Income Commentary for December 2021
Performance Summary
FolioBeyond's algorithmic Fixed Income strategy was marginally positive in December, returning 0.07% and 0.09% in its dynamic and static volatility versions. The strategies outperformed the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") which returned -0.26% for the month. For 2021, the FolioBeyond strategies have outperformed AGG by 201 and 259 bps in its dynamic and static volatility models, respectively.
The Treasury yield curve reversed the flattening rally in November and registered a bear flattening selloff. The 10-year yield rose by 9 basis points while the 2-year yield spiked up 19 basis points. Our portfolio lightened up its intermediate Agency exposure while it continued to be more overweight the short duration sector through Treasury Inflation Protected Securities (“TIPS”), Treasuries, and a modest allocation to Bank Loans.
Source: FolioBeyond’s returns are from SMAs on Interactive Brokers (from January 1, 2019, for Static Volatility and from November 3, 2020, for Dynamic Volatility) and back-tested simulated results prior to that. AGG and Multisector Bond Category returns are from Morningstar.
* FolioBeyond Dynamic and Static Volatility returns are net of underlying ETF fees and 30 bp assumed management fee. Although the information herein is believed to be reliable, FolioBeyond makes no representation or warranty as to its accuracy, and information and opinions reflected herein are subject to change at any time without notice. The past performance information presented herein is not a guarantee of future results.
Highlight: Year-End Recap and Outlook for 2022
The confluence of factors ranging from inflationary pressures, declining unemployment rate, Covid-19 outbreaks, and changes in Fed actions led to increased volatility in the bond market. The 10-year Treasury yield finished the year up 61 basis points but traded within a wide range. The 2-year Treasury yield, however, exhibited a steadier upward trend from mid-year, rising by 60 basis points for the year.
Given the relative flatness of the yield curve and changing relative value relationships, especially in the intermediate/long duration sectors of the bond market, FolioBeyond’s fixed income strategy was generally positioned short relative to the duration of AGG. Yield pickup was driven by credit exposures in the short end of the market, including floating rate instruments where the exposure benefited from rising short term rates. Additionally, given the dynamic nature of the model, it found short term opportunities in the intermediate and long Treasury sectors when the curve was steeper. All these factors contributed to the outperformance of FoliBeyond’s strategy versus the AGG, while maintaining similar projected return volatility targets. Realized volatility however, turned out to be materially lower for the FolioBeyond strategy than AGG for the year.
Looking forward to 2022, we outline below some of the major opportunities and risk factors to keep in mind given the current state of the markets.
· Duration management in a bear market: Whether it is a bear flattener or a bear steepener, the current inflationary environment characterized by negative real yields and tightening Fed policy requires investors to put additional focus on duration management. Whether it’s floaters or MBS Interest Only Strips (“MBS IOs”), there are instruments that will shorten or reduce the overall duration risk without sacrificing current income.
· Negative convexity risk in a selloff: The market has not witnessed a significant selloff recently with negative convexity and duration extension playing out. Callable corporate bonds will extend as call options go further out of the money. MBS will extend as prepayment speeds are expected to decline. As these types of instruments extend in a selloff, it can feed on itself as it triggers further selling to maintain desired duration targets.
· Spread products and asset allocation: Spread products have generally narrowed to tight levels during the past 18 months. Going forward, we are likely to see more spread volatility as the economic expansion favors certain sectors and inflationary pressures have uneven effects on spread products. This type of volatility creates risks but also opportunities to rebalance across different sub-sectors as relative value relationships change.
· Yield curve strategies: As the bond market continues to get varying signals about future Fed actions, path of inflation, and economic growth, we are likely to see volatility in the shape of the curve. If the belly of the curve sells off faster, the intermediate sector can offer attractive opportunities. In contrast, there will likely be times where the wings or barbell strategies might offer better risk adjusted returns.
FolioBeyond’s Fixed Income model is well positioned to optimize fixed income allocations based on changing relative value relationships on a forward-looking basis, with embedded options and default risks price out, along with other risk factors including momentum effects. We are also adding a new rising rates ETF (ticker: RISR) to the mix of existing 23 sector ETFs that we currently monitor. This will provide another uncorrelated risk/return profile in our mix of possible sector exposures, which should improve overall portfolio performance over time. The model’s optimization analysis is updated systematically on a daily basis with re-balancings being triggered as risk levels deviate beyond specified thresholds.
