Trend-following in a low-yield environment

An analysis on return opportunities provided by government bond futures for trend-following CTAs in a low-interest rate environment

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In a world where interest rates have fallen into ultra-low or negative territory, more and more investors are questioning the diversification benefits of a fixed income allocation in a portfolio context. It is highly unlikely for rates to fall much further from current levels, and the expected upside from holding a long bond exposure is more limited than ever before. With bonds having supposedly lost their shine, many investors have been questioning whether trend-following strategies will manage to continue delivering attractive risk-adjusted returns and providing diversification during equity market crisis periods. In order to express a view on the subject, we argue that a thorough understanding and historical analysis of the key return drivers of bond futures is a necessity. Relying on such analysis, we show that carry, a pure function of the shape of the yield curve, has accounted for more than half of the returns earned from holding a long bond position since 2005. The return contribution coming from carry has been even more predominant during normal and bull markets. Inversely, in times of equity market stress, yield depreciation has been the main driver of strong bond future returns. With global yields at all-time lows and carry having largely contracted towards zero as a consequence of flattening yield curves, we believe it is unlikely that the superior return contribution and natural diversification benefit of bond futures observed during the past 15 years will persist. Such contraction of carry, however, offers new attractive return opportunities for trend-followers, such as the building-up of short positions in bond futures in a rising rate environment. We conclude that a systematic, diversified and risk-adjusted approach to trend-following remains as valuable as ever to adapt to and benefit from any new yield curve scenario or return opportunities in other asset classes that may arise.

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Quantica Capital
Published
September 9, 2020
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