Systematic Fixed Income

CHAPTER 3Fixed Income – Tactical Asset Allocation

OVERVIEW

This chapter lays out a framework for timing the two primary traditional risk premia in fixed income markets: the term premium and the credit premium. Building on our understanding of the sources of these risk premia discussed in Chapter 2, we will start to think about forecasting when those risk premia are expected to out (under) perform. The framework is designed to be general to identify the relevant inputs for timing models. We are not designing the “best” possible timing models. That arduous task is for the fixed‐income investor. That said, the simple timing models introduced in this chapter show some promise for out‐of‐sample forecasts of risk premia. Data mining concerns are especially important with timing models, as there is a very limited dataset to work with (one history for one asset), so we will discuss the importance of point‐in‐time timing models and unconscious bias that creeps into reworked timing models.

3.1 MARKET TIMING – TERM PREMIUM

3.1.1 Framework for Timing

In Chapter 2 we saw that long‐term US government bonds generated an attractive risk‐adjusted excess (of cash) return over the past century. This is known as the term premium. Obviously, although the term premium has a positive average excess return, there was considerable temporal variation. Indeed, the annualized average excess return was 1.8 percent and the average annualized volatility was 5.1 percent over the past century. The asset ...