Core idea:
The core principle of the paper is "equity values drop when credit risk rises and vice versa". This paper applies this relationship at index level. The method here is a long-only strategy and uses SPDR sector ETFs (XLE, XLY...) as the assets to rotate for the portfolio. Methodology:
- Select a credit index or basket of credit instruments as proxy for credit risk to the portfolio. The credit index chosen here is Bank of America/Merrill Lynch's US High Yield B index i.e., HY/B.
- Using 6 month time frame (i.e., 26 weeks, weekly frequency) calculate a fair value for each sector ETF utilizing HY/B index values. The model is calibrated via Ordinary Least Squares (OLS) linear regression. Look at the figure below for a better explanation.
- ETF fair(HYB market) = A * HYB market + B
- Then estimate the disconnect for each sector ETF i.e., calculate how far, on a percentage basis each sector ETF is away from fair value using below formula. Given it is regression based, some ETF disconnect values will be positive and for other ETFs it would be negative values.
- ETF disconnect = [ETF fair - ETF market] / ETF market
- Now rank the ETFs in descending order of their disconnect values. The idea being the top ranked ETFs have the greatest disconnect and so should generate high returns relative to the bottom ranked ETFs.
- Buy the top ranked N assets. Replace them in portfolio whenever the top ranked assets change. Assume an Equal-Weighting scheme for portfolio sizing.
Twist:
One problem with the above is, in times of market stress, the portfolio will have severe drawdowns. If you had noticed, in the above model, we ignored the sign of disconnect values and just ranked all of them. So one twist is to utilize the sign of disconnect values (postive or negative) and play the tactical asset allocation game i.e.,
- Each week, choose the N top-ranked ETFs.
- For each of the chosen ETFs:
- If the fair value is greater than market value (i.e., plus sign), then invest the asset share in that ETF.
- If not, then invest the asset share in 3-month Treasuries instead. Notes:
- The paper uses previous 26 weeks of data exclusive of the current trading day to build the regression. Similarly HY/B value is published the following day. So the model uses previous day's HY/B value to calculate fair value for each ETF.
- 6 month (i.e., 26 week) time frame is chosen as the authors felt it is long enough to develop a meaningful relationship between credit index and market but short enough to detect regime changes quickly.
- The HY/B index values are obtained from FRED database. The sector ETFs values are obtained from Yahoo finance. The model in paper assumes equal-weighting of the assets in the portfolio.
Why credit markets as the proxy?
The basic idea is a firm's asset value, equity value and its debt are interconnected i.e., related to each other. This relation was proposed by Robert Merton and that model goes by the name "Merton Model". Now the same concept applies at index level as well.
Merton Model - Think of equity of a company as an European call option on the firm assets i.e., you pay the premium today and when the call option matures, you get to cash in by selling it. Similarly think of liabilities/debt as the option strike price. Now think of the firm's asset value as the instrinsic value of the option. So the profit you get on call option at maturity is whatever value of the option is on that day - the strike price of the option - the premium you paid. This model seems can be used to estimate the probablity the company will go belly up (i.e., default) as well as the credit spread on the debt. Anyway, this is what I understood from a quick google search.
This paper uses the corporate credit spreads as the proxy for the credit risk. So for implementation, the paper uses the option-adjusted spreads for Bank of America/Merrill Lynch's US High Yield B index i.e., HY/B as proxy. Note: the paper uses same credit index i.e., HY/B as proxy to judge relative value for all equity assets in the portfolio.
Model characteristics:
In declining markets, the strategy would help in limiting losses. On other hand, in bull markets the strategy will throttle gains. The reason being the strategy is generally invested atleast partially in Treasuries. Overall the tradeoff of lower gains in up markets is countered by limiting the portfolio drawdown. It is psychologically challenging to the investors.
If the investor takes a long view i.e., a lower volatility strategy that limits drawdowns can be far more desirable then a buy-n-hold strategy or one that exposes as portfolio to sharp market corrections. Unfortunately many feel satisfied more based on relative comparisons with joneses than with absolute comparisons.
It is more suitable for investors who take 2-3 year view for the strategy compared to the ones who focus more on short term results.
Source Paper: Equity sector rotation via credit relative value
Wrap up:
My guess is this paper got award due to the relative value concept i.e., using credit index as proxy to calculate the fair value of the underlying asset and use the disconnect from value as the criteria for ranking the assets. On the whole, it is a good paper and interesting concept.
Though the returns are good the volatility and drawdown numbers are bit high. I think it would be a good strategy to consider if one can figure a way to reduce the drawdowns and volatility of the strategy returns. Some areas to investigate would be like using volatility targeting instead of equal-weighting scheme. Another would be using strategy diversification. When I get more time, I want to test this strategy along with another momentum strategy and see how the correlations would look like.
Another area would be figuring out a better credit index proxy besides HY/B and is negatively correlated with equities. My knowledge about credit markets and financial engineering techniques is limited. I appreciate if any readers with deeper background in credit markets can suggest proxies alternative to HY/B that one can investigate.
Finally, nearly all the subscribers to this blog are by word of mouth. So my usual request - if you found this post useful then can you please share this blog with couple of your friends/colleagues. I appreciate it.
Wish you all good health & good trading!
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