Last Updated on April 19, 2022 by Quantified Trading
Junk bonds are probably an asset class that very few traders are involved in. Junk bonds tend to correlate with the stock market, but junk bonds seem to trend more than stocks, which opens possibilities to make uncorrelated junk bond trading strategies.
This article explains what a junk bond is, why it correlates to the stock market, and how you can backtest this asset class. We backtest and look at a few junk bond trading strategies.
What are junk bonds?
Junk bonds are my one true love in the financial arena, and even that’s an understatement of my appreciation for this asset class….For me and junk bonds it was definitely love at first sight.
– Gary Smith, How I Trade For A Living, page 183
A bond is a fixed income security issued by a company (mostly companies, but it could also be a government entity). When the bond is issued it pays a coupon of x percent at N intervals per year. The bond is in reality a loan from the investors to the company.
The price of the bond might fluctuate depending on the overall interest level, the mood swings of Mr. Market, or improved or deteriorated prospects for the issuing company. When the price of the bond drops, the coupon yields more to reflect the increased risk. Thus, the value of the bond and the yield always move opposite.
It is called “junk” because they have a higher risk of default. A default happens when the issuing company is no longer able to pay the coupon.
If the risk of default is high, the higher the original coupon, but the yield fluctuates wildly over the life of the bond before it matures or is called back. Ratings are done by rating agencies, for example, Moody’s and Fitch.
Ratings below BBB and Baa are expected to have more defaults and are thus labeled “junk bonds”. Ratings higher than this mean the company has “investment grade”.
The term “junk” scares many potential investors and traders away from this asset class. But many well-known companies have junk bond status: Ford, Tesla, and Netflix are all below investment grade.
Keep in mind that junk bond yields have fallen dramatically over the last 40 years, just like Treasury yields. For example, in 1991 junk bonds yielded 17%, in 1998 11%, while they today have a minuscule 4% yield.
Does this reflect the true risk? Who knows, only time will tell. If you are a short-term trader it shouldn’t matter so much, except that the long-term trend might go down if rates go up.
The tailwind from falling interest rates has been significant. That, and the combination of “income” from the coupon, has made junk bonds compound at around 8% since 1980. This is the performance of Fidelity’s junk bond mutual fund:
Junk bonds vs stocks
According to a research paper by Alliance Bernstein, junk bonds have historically correlated 0.61 to the S&P 500 and 0.6 to MSCI World Index. This is pretty high and indicates that junk bonds are more correlated to the stock market than to the bond market.
Below is a chart showing the performance of HYG (a junk bond ETF, see more below) and the S&P 500:
The lower pane is S&P 500. Especially in times of market turmoil, we can see that both markets tend to drop sharply, and the correlation increases. Junk bonds offer no safe haven like government Treasuries.
Why would investors buy junk bonds?
Higher risk means higher interest rates (coupon). Fixed interest payments might avoid behavioral mistakes as you most likely continue receiving the coupon in times of stress, of course depending on the severity of the recession and the risk of default. Furthermore, bondholders get paid before equity owners if the company in question should go bankrupt – thus less risk.
Because of this, it’s fair to expect lower returns from junk bonds than stocks. Or is it?
Since junk bonds become an asset of their own in the early 1980s, the group as a whole has more or less kept pace with stocks, but with much lower volatility:
The graph above, made by AllianceBernstein, is a bit old, but the statistics still hold. Worth noting is the less volatility. If we risk-adjust the returns and compare them to the volatility, junk bonds have performed better than equities over the last 40 years.
However, keep in mind that the interest rates have been on a decline over the whole period. This has resulted in higher junk bond prices and the coupon needs to reflect the falling yields. There is, of course, no guarantee that this will continue, but it’s fair to assume that equities also will take a hit if rates turn around and head higher. Most likely, junk bonds would have fared much worse in 2008/09 if it wasn’t for the FED pumping in billions of dollars.
Junk bond ETFs
The easiest way to get exposure to junk bonds is to buy junk bond ETFs or mutual funds.
There are many junk bond ETFs but the two most popular are iShares iBoxx $ High Yield Corporate Bond ETF (ticker code is HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK). Both are highly liquid with a daily turnover of 44 and 11 million shares traded daily.
In this article, for backtesting purposes, we use HYG for the most recent time frames and Fidelity’s junk bond mutual fund (VWEHX) for longer time frames. The latter has a history back to 1980 and serves as a proxy for junk bonds in our backtests. However, there is no guarantee that VWEHX is a good proxy for the future.
Monthly seasonalities in junk bonds
Let’s start by looking at what has historically been the best months for junk bonds. We used Fidelity’s mutual fund for this test to get a decent amount of observations:
The worst month is September, exactly the same as in the stock market. (Please read our article called What is the worst month of the year for stocks?)
Day of week seasonality in junk bonds
Let’s backtest to look for any strong seasonalities based on the weekday. We use backtest by using HYG:
The first column shows which day it is, but we buy at the close and sell the next day’s close. Thus, “day of week” has a lag of one day. This means that the first row is the performance from the close of Monday until the close of Tuesday and so on.
Monday is the weakest day while Tuesday is the best. This might hint that there is Turnaround Tuesday effect in junk bonds.
Daily intraday seasonalities in junk bonds
The table below is the performance from the open to the close each day (we use HYG):
There is no money to be made intraday unless you are a very gifted trader. Just like S&P 500, the long-term gains come from the overnight edge.
One other trading seasonality in junk bonds
We tested another junk bond trading strategy that is based on a monthly seasonality:
The junk bond strategy holds on average just a few days but seems to have performed pretty well. We don’t want to publish the strategy because we trade it ourselves and we might publish it for our paying subscribers.
Trend-following in junk bonds
By using the optimization feature in Amibroker, we tested many trend-following strategies. It works reasonably well, much better than in stocks, and below we have just a random example of one of the junk bond trend-following strategies we tested:
The strategy is long-only and the returns seem to be slightly diminishing recently. However, the CAGR is 9.6% while being invested 73% of the time, much better than buy and hold. Max drawdown is a tiny 6.5% and 2018 was the only year with negative returns.
If we flip the strategy and go short, the average gain per trade is also positive, but the headwind from the positive trend makes it less profitable than longs, and most likely not tradeable (until rates go up?).
If we use the same strategy in the S&P 500 the returns are much lower and more erratic. This means the “trends” seem to be much more robust in junk bonds than in stocks.
We want to emphasize, again, that junk bonds have had a powerful tailwind in the form of lower rates. Today we might be at crossroads where this is no longer. Only time will tell.
Turnaround Tuesday in junk bonds
The turnaround Tuesday trading strategy has been a very simple, yet effective trading strategy in the stock market. Does it work in junk bonds, is there a turnaround Tuesday in junk bonds?
Yes, there seems to be a similar effect, but not as distinct (below is from the close of Monday until close on Tuesday given two variables):
Junk bonds trading strategies – ending remarks
Please be aware that the junk bond strategies presented in this article might yield different results depending on the instrument you are testing on. For example, HYG owns different junk bonds than JNK and Fidelity’s VWEHX.
Nevertheless, we believe by adding some junk bond trading strategies you can improve your trading because they most likely add diversification to your portfolio.