Ok, last credit spread analysis (just have to get it out of my system)…
Previously, I showed that rising credit spreads (AKA an increasing difference between corporate and treasury yields) has generally been more bullish for the stock market, but that just because credit spreads are high or low hasn’t had a consistent impact on the market.
In this report, I want to show that the credit spread itself has been pretty predictable. Put simply, monthly average credit spreads exhibit follow-through: months when spreads increase tend to be followed by additional months of increase, and vice-versa.
All interest rate data from St. Louis FRED Database (1970 to 07/2008)
In the months following months when average credit spreads decreased, the spread declined on average an additional -1.3% and only rose 41% of the time. Conversely, in the months following when spreads increased, average spreads increased an additional 2.0% and rose 60% of the time.
Geek note: the % change numbers above are a % of the previous spread. Example: a change in spreads from 1.0% to 1.1% would be an increase of 10%, NOT 0.1%.
There are a number of trades that would take advantage of this observation. I won’t test any specifically here because it’s beyond the scope of this report, but just for giggles, let’s assume that you could just trade the spread directly. I’ll assume we go long in the month following increasing spreads and short following declines.
Chart logarithmically scaled
The blue line shows credit spreads since 1970 and the red line the prediction results. As the chart shows, month-to-month follow-through in credit spreads has been very consistent for nearly 40 years.
With spreads higher in August, this could presage further increases in September, but I’m not very confident in that conclusion because we’re approaching historical highs and unchartered waters.
Happy Trading,
ms
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Filed under: Follow-Through, Trading Strategies, Treasuries & Interest Rates | 12 Comments
If that is true for credit spreads, and my experience as a corporate bond manager is consistent with that, then it is also probably true for implied volatility, since the two are highly correlated.
RE to alephblog: probably a dumb question but, it’s probably true for the implied volatility of what?
P.S. i’m a big lurker at your blog – great stuff sir.
ms
Would a good way of exploiting this be to use the ETFs of HYG and SHY?
Also, when you say treasuries and corporate bonds, what are we specifically talking about? 2yr TR vs. 2y CR? AAA? AA? A?
RE: to dskills: ooops, you made me realize that I gave the details of which credit spreads I was talking about on both of the first two parts of this topic, but forgot on this one. Apologies. I’m looking at spread between BAA corporates and 10-year Treasuries. Similar conclusion for similar rated corps and similar maturity UST that i looked at.
Thanks,
michael
Ok – never mind – I read the prior post and figured out what data you were looking at. Here’s my question – in putting together a system, you’d have to either be long or short either the corporate rate or the treasury rate. But there are many ways the yield rate could change – I’m trying to figure out how to deal with the different combinations. You could have:
- T-rate up/C-rate down
- T-rate down/C-rate up
- T-rate up/C-rate up
- T-rate down/C-rate down
And because you’re looking at month-over-month changes, you could have cases where both rates are up, but the spread still changes….so if you trying to figure out whether you should be long or short the two securities, there seem like a lot of options. Any further thoughts? Or am I thinking about this totally wrong?
Ok – got it – was able to reproduce your spread chart – thanks for pointing to that data source – pretty cool.
But a further question: you’ve got a bunch of different ways that the spread could change – so is there any way to trade the spread directly? Or does one have to figure out, then, the persistence of the rate changes in the individual instruments?
As far as I can see, as long as you’ve got to compare month-over-month changes in the two rates, you could have:
- T-up/C-down – spread expanding
- T-up/C-down – spread contracting
- T-down/C-up – spread expanding
- T-down/C-up – spread contracting
- T-up/C-up – spread expanding
- T-up/C-up – spread contracting
- T-down/C-down – spread expanding
- T-down/C-down – spread contracting
I’m not sure how one would determine how to act in different cases….
Thoughts appreciated!
RE to dskill:
Three thoughts:
1. I think I would treat is as a pair (although I haven’t actually tested this) and go long AND short the appropriate instruments to play a widening/narrowing spread.
2. I think the comment you made in the first post about having to retest for the specific TRADEABLE instrument was spot on. I’ve just used indices in this post, so if I were applying it in the real world, I would do a final test using the actual trading vehicles.
3. I think this concept has a lot of room for improvement – some ideas off the cuff: daily and weekly (instead of monthly) spread follow-through, spread follow-through when spreads are relatively high or low (in the second post we tested hi/lo performance but not hi/lo follow-through), and other approaches like spread moving average crossovers instead of just the simple follow-through approach.
All very good questions dskills. Let me know what you come up with. As I said, I think that there is a lot of room for improvement, but I find that if I make things too geeky, most readers will tune out so I try to keep things pretty straight-forward. Looking forward to more from you.
P.S. are you the same dskills from the Wealth-Lab site?
michael
I think my biggest limitation will be my own math skills and data – but I’ll probably do some work on this week/next week assuming I can find the data. Finding instruments to trade is clearly going to be challenging, and it is likely that any derivative (such as an ETF) is unlikely to match the original instrument – so more research needs to be done here. You’ll also need to find instruments that match in terms of price (at least somewhat) so that you can have balance in the trade.
I think you’re right about playing it both ways – the challenge is that the spread can widen and narrow in a variety of ways. If both go up, and the spread still widens, then one side of the trade would be a winner and the other side a loser – you could still end up with a loser. Contrast that with if the spread widens by one going down and the other going up where the long and short would work. Might be worth checking for persistence in the individual rate moves.
I am indeed that dskills (also known as droskill) – you can find me on my own website at http://skillanalytics.wordpress.com. You’ve inspired me a lot in the past two years – so it should be no surprise I enjoy reading your blog.
RE: to dskills/droskill – aha…you were already on my list of blogs that I follow. Would love to collaborate with you in the future on something – and hope to see more posts from you on your blog!
michael