This strategy relies on the high yield bond (index) fund's alpha as its trend indicator to invest in high yield bond.
High yield (junk) bonds are perhaps the most "trendy" assets: when a direction is established, it tends to continue. This trendy behavior is long-standing and statistically significant. Based on Carpenter Analytix, such a trend could be captured by their alpha. By using moving alpha we can track excess return of the underlying security which we want to invest in. Apha is effective in this role because it excludes some components driven by covariance with other assets.
This strategy has the following parameters:
- UnderlyingSecurity: (index) fund used to calculate the alpha and acts as a signal.
- AlphaLength: the number of months used to calculate alpha. Notice in ValidFi, Alpha is calculated daily. So it is really calculating AlphaLength*21 days (21 trading days per month).
- SecurityForSwitching: when alpha is negative the strategy switches to this security. Usually CASH or a short term bond fund such as SHV or SHY.
- AlphaBenchmark: the benchmark used to calculate the alpha. Usually should be CASH or broad bond index fund such as VBMFX.
- SecurityForTrade: when alpha goes to positive.
The fund used as the signal UnderlysingSecurity could be a mutual fund (such as Vanguard High Yield Bond Fund VWEHX or Price High Yield Bond Fund PRHYX) or the SecurityForLong itself. In general, it is more effective to utilize a general (index) fund as the signal (as it is more stable and less prone to daily fluctuation due to trading). The SecurityForLong could be a mutual fund (such as VWEHX), an ETF (such as HYG or JNK) or a closed end fund (CEF) such as PHK, EAD etc.
The Strategy has the following steps:
- At every day's closing, calculate the (moving) Alpha of UnderlyingSecurity during the past period of 21*AlphaLength days
- If the Alpha is positive, take the long position of SecurityForTrade (or if there exists the long position, do nothing)
- Else if the Alpha is not positive, switch to SecurityForSwitching (usually CASH or short term bond fund).
Other ValidFi strategies which utilize the trend of high yield bonds
- High Yield Bond Timing Strategy uses high yield bond fund price's trend reversal
- The 125 05 Timing Model of High Yield Bond Strategy by Gerald Appel is another method for high yield bond fund price's trend reversal.
- High Yield Bond Alpha With Short takes short positions when Alpha goes to negative.
See Also
- Carpenter Analytix, Junk Bond Alpha, www.carpenteranalytix.com.