What You Need to Know About Bonds and Managed Futures before Interest Rates Rise

What You Need to Know About Bonds and Managed Futures before Interest Rates Rise

What You Need to Know About Bonds and Managed Futures before Interest Rates Rise via Attain Capital

What makes the financial world go round?   Stock prices?  Not quite. Job numbers? Good try. James Bond?  No, but close and something we wish were true with the new movie due out tomorrow.

No, in our humble estimation – it’s the thing which made Greenspan, “The Bernank,” and now Yellen household names. We’re talking interest rates – and their market personification – bond prices. Just yesterday, Fed chairwoman Janet Yellen hinted at the “live possibility” of an interest rate hike in December, the Treasury Department auctioned $26 Billion in two year notes at a higher yield, and the CME Group is now giving the FOMC a 60% chance of raising rates in December – sending the financial twittersphere into a tizzy.

While the rest of the world is concerned about how bank deposits, mortgage rates, and mezzanine debt will shake out in a world where the Fed is raising rates for the first time since 2006; we’re looking at what types of investments are likely to benefit from the increased bond market volatility and potential price trends which could come from a rising rate environment.

This Credit And Equity Fund Saw Sizable Contributions From Its Stocks In Q3

Arena Investors Chilton Capital Management Schonfeld Strategic Advisors Robert Atchinson Phillip Gross favorite hedge fundsThe DG Value Funds were up 2.7% for the third quarter, with individual fund classes ranging from 2.54% to 2.84%. The HFRI Distressed/ Restructuring Index was up 0.21%, while the HFRI Event-Driven Index declined 0.21%. The Credit Suisse High-Yield Index returned 0.91%, and the Russell 2000 fell 4.36%, while the S&P 500 returned 0.58% for Read More

And first up on our list – managed futures and their core investment strategy, trend following.

Bonds Dominate a Basic Trend Following Test

To show just how important a volatile and/or trending bond market is to managed futures, we enlisted some of the smartest people we know to run a simulation showing the portion of a trend following model’s performance comes from the bond sector. We called Toronto, the home of Integrated Managed Futures Corp. (IMFC) –  who’s the manager of the Attain Global Macro Fund,  to run a simulation back to 1990 using a basic trend following model. The model used a simple 60/120 moving average cross over to signal either a long, short, or flat position in each market in a portfolio of 49 markets across the bond, stock index, currency, grain, energy, meats, metals, and softs. They normalized the position sizing by using a fixed 0.25% risk allocation based on the 99% VaR for each market, starting the portfolio with a fictional $1 million and allowing fractional lot sizes for the sake of simplicity.

Finally, they applied sector limits so that no one market sector had a larger share of performance due solely to that sector containing more markets.

2 Pie Charts Return Drivers Managed Futures
Managed Futures

Please note: the numbers throughout this article are a simulation of the educational topic outlined herein, they do not represent trading in actual accounts nor the hypothetical track record of an investable model. It is intended for educational purposes only.

Show Me the (Bond)jamins

The results of the test confirmed what we’ve experienced in real time over the past 20 years – with the amount of performance attributable to the bond market about double the amount of returns coming from any other market sector; as much as Grains, Energies, and Metals combined.

This simple trend following model saw a hypothetical return of 4,666% over the course of twenty five years, with about 1,400% coming from bond markets (meaning 1/8 of the portfolio was responsible for about 1/3 of the returns – making Bonds the Michael Jordan of Trend Following.  That’s a far cry from boring, and why CTAs usually get excited when they see a new bond position initiated. It is also worth noting that close to 60% of returns since 1990 for this model were from financials (bonds, stocks, and F/X or currency futures). Now you know how the Wintons of the world are able to manage 10s of Billions of dollars (hint – it’s not in Lean Hogs).

If you’re wondering if this was lumpy performance (ie. coming in just a few large spurts) or rather consistent, our friends at IMFC gave a look into that as well, plotting out the bond performance in each year going back 25 years.

Bond Sector Performance by Year 1990 Managed Futures
Managed Futures

(Disclaimer: Past performance is not necessarily indicative of future results)
Data = The bond sector accounts for the total returns of YBA, TY, US, FV, CGB, EBL, FLG, JGB, FEI, FSS, YTC, EBM)

There’s a reason Managed Futures (and specifically Trend Following strategies) load up their portfolios with bond markets and love to see those bond markets move.   You can see above that the bond component of the portfolio has been a rather steady performer for this trend following model, seeing profits in about 70% of the years and averaging about 7.5% during those winning years (based on risking 0.25% per trade, on a non-compounded basis). (Disclaimer: These results are a simulation of the educational topic outlined herein, they do not represent trading in actual accounts nor the hypothetical track record of an investable model. It is intended for educational purposes only).

Note: The shaded areas are during higher interest rate environments, in which managed futures found return drivers in the bond market, especially 1995, with the highest return of 18.24%.

The Kicker = Crisis Period Performance

Now, here’s where things get fun, and we look at the bond component of this proxy trend following model during crisis periods. After all, that’s one of the main reasons people look at managed futures – to get access to that crisis period performance; and if bonds aren’t showing up during those periods – it probably doesn’t matter what they do the rest of the time.  We first checked to see that this test trend following model correlated highly to managed futures in general during the past six crisis periods, and it did with positive performance in all six crisis periods. We then looked at what the performance of just the bond sector was during each of those periods, and finally calculated what share of the model’s performance during those crisis periods was due to the bond sector. Turns out about 1/3 of the performance during the crisis periods comes from Bonds.

crisis_period_updated Managed Futures
Managed Futures

Why does this happen…well crisis periods in the stock market are usually met with a ‘flight to safety’ trade where investors dump risky assets for perceived less risky assets like US Treasury Notes, German Bunds, and Japanese Govt. Bonds. All that money rushing into bonds tends to push their prices up, causing a trend the models can identify and ride higher.  What about a market crisis caused by rates going higher (bond prices lower) – when the flight to safety might not happen? Good question, but the answer is likely to be the same thing will happen, just in reverse; with trend followers equal opportunity employers – meaning they are just as willing and able to be short bonds (prices down, interest rates up).  Indeed, we wouldn’t be surprised to see some 2016 headlines reading algo futures traders cause interest rates to rise, pushing the stock market into the red – just as they were blamed for the stock sell off in August.

So there you have it – trend following models crave trends and volatility in bond markets as if it is a third of their performance profile.  And if you’re into the WHY beyond the performance, of how that can work without the bonds being more than 1/3 of the risk the portfolio takes – we’ll cover that in a follow up post next week. Make sure not to miss it by getting our weekly emails of our latest findings in the alternative investment space.

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