Momentum strategies are based on the observation that assets with the best recent performance tend to outperform the market. This isn’t supposed to be true, at least not if you believe in the efficient market hypothesis, but studies of US stocks, commodities, currencies, and a host of other asset classes shows that it is.

“Curiously, even though the market for nominal U.S. Treasury securities is among the deepest and most liquid in the world, no one has rummaged through government bond term structures to find similar strategies that work, no matter what the future general direction of interest rates,” writes J. Benson Durham, assistant VP of the Federal Reserve Bank of New York’s markets group.

Bond momentum strategy beats the market with a high information ratio

The basic model that Durham analyzed sets portfolio weights for six maturity buckets (1 – 3 years, 3 – 5, 5 – 7, 7 – 10, 10 – 20, 20 – 30) between zero and one to match the weighted average duration as the benchmark so that short sales are excluded and excess returns can’t be caused by parallel interest rate changes. Within those two constraints, the model maximized exposure to the maturities with the best recent performance.

The result was an average annual excess return of 120 bp over the benchmark with a standard deviation of 153 basis points, for an impressive information ratio of 0.79. The results robust to the size of the momentum window (which isn’t true for all asset classes), the strategy has a positive skew (meaning that outliers are more likely to be positive than negative).

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Long/short momentum strategy has 207 bp excess returns

While it’s possible that the term structure momentum strategy could be correlated with some other asset class, Durham tested the results for exposure to S&P 500 returns, macroeconomic variables, interest rate volatility, and other common risk factors and found that term structure momentum wasn’t related to any of them.

Implied bid-ask spreads would have to range from 9bp – 56bp to prevent investors from using this strategy profitably, while actual spreads tend to be just a couple of basis points, and investors can do even better with a long/short strategy that goes long on outperforming maturities and short underperforming ones. This ‘Treasury market neutral’ strategy has average annual excess returns of 207 bp, an information ratio of 1.01, positive skew and comparable trading costs.

“These simple momentum trading rules seem to represent more than fair compensation for risk,” says Durham, though he warns that more research is needed.