Characterising Investment Styles in Fixed Income Markets

Vasant Naik Head of FI Quantitative Strategies

May 2010

STRICTLY PRIVATE AND CONFIDENTIAL

Research team
Fixed Income Quantitative Strategies

Vasant Naik Srivaths Balakrishnan

vasant.naik@nomura.com srivaths.balakrishnan@nomura.com

Mukundan Devarajan
Tom Andrews

mukundan.devarajan@nomura.com
thomas.andrews@nomura.com

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Overview
Top-down investment styles in Fixed Income markets Long sample unconditional performance of investment styles Macro properties of returns of investment styles Comparison of Fixed Income Styles with those in Equity markets

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Top-down investment styles in Fixed Income Markets

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Classification of Top-down Investment Styles in Fixed Income Markets

Top-down Investment Styles

Price Momentum
Return continuation

Carry
Random walk in asset prices

Value
Mean reversion from extremes in asset prices

Macro Momentum
Persistence of macro regimes

Fixed income asset classes

Interest rates

Corporate Credit

Currencies

Commodities

Source: Nomura Research

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Top-down Investment Styles in Fixed Income (contd.)

Price Momentum:

Buy assets with strong returns against those with weak returns

Macro Momentum:

Buy risky assets in periods of economic strength and less risky ones in periods of economic weakness

Carry:

Rates: Buy bonds when yield curves are steep

Credit: Buy corporate credit when credit curves are steep

Currencies: Buy currencies with high interest rates against those with low interest rates Commodities: Buy backwardated commodities and sell those in contango

Value:

Buy when prices are significantly below fair value and sell when they are above

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The Performance of Momentum and Carry-based Strategies is Stronger than that of Value
Performance of investment styles: 1976 2010 Momentum 1976-2010 Average annual excess returns (%) Annualised information ratio Skew Hit Ratio(1) 1990-2010 Average annual excess returns (%) Annualised information ratio Skew Hit Ratio(1) 3.2 1.40 1.5 72% 1.4 0.73 -1.0 63% 0.4 0.18 -2.0 57% 3.3 1.47 1.4 72% 1.4 0.77 -0.4 63% 0.5 0.26 -1.5 57% Carry Value

Source: Nomura Research All performance numbers are for volatility-adjusted investment strategies and are before transactions costs 1. Hit ratio is defined as the proportion of months with strictly positive excess returns
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Correlation between Style-based Strategies is not Markedly High...

Correlations between style-based strategies

Momentum and Carry

Full Sample Correlation (1976-2010) Median of rolling 5-year correlations 1981-2010 1990-2010 1999-2010 2007-2010 3% 3% -4% 0% 7%

Momentum and Value

-18%

Carry and Value

41%

-25% -31% -43% -26%

45% 53% 46% 3%

Source: Nomura Research

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...which Prompts their Application as a Portfolio of Style-based Investments

1976-2010 Avg. ex. returns (% pa) Ann. information ratio Skew Hit Ratio 1990-2010
1%

Annual performance profile(1) 2.1 1.60 1.4 71%

2% 6% 5% 4% 3%

Avg. ex. returns (% pa) Ann. information ratio

2.1 1.59

0% -1%

76

79

82

85

88

91

94

97

00

03

06 20

19

19

19

19

19

19

19

19

20

20

Hit Ratio

70%

Source: Nomura Research All performance numbers are before transactions costs. The portfolio is constructed with the following risk weights: Momentum 50%, Carry 25%, Value 25% 1. The actual excess returns for 2008 are 7.1%. The chart has been truncated at 6% for improved readability.
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20

Skew

1.2

09

Returns of Style-based Strategies Also Help Attribute Risk Exposures of Portfolios

rt Portfolio M rt Mmtm C rtCarry V rtValue t
Regression of Hedge Fund Index excess returns on those of style-based portfolios (1990-2010) Momentum ( M ) HFRI Fund of Funds Wtd. Composite -1.0*** Carry ( C ) 0.7*** Value ( V ) 0.0 R2 16%

CS Tremont Managed Futures HFRI Macro Systematic Diversified HFRI Relative Value HFRI Event Driven

1.8*** 0.2 -0.9*** -1.2***

1.7*** 0.7*** 0.3** 0.6***

-1.3*** -0.5** 0.2 0.0

25% 4% 29% 19%

Source: Nomura Research, HFRI, CS Tremont, Bloomberg ***, **, * represent significance at the 97.5%, 95% and 90% levels
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Macro properties of style-based investment strategies

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Momentum and Carry Trades Perform well in Economic Expansions...

Annualised information ratios of style-based portfolios in Expansions 1976-2010 Full Sample unconditional Expansion periods Early expansions Late expansions Momentum 1.47 1.60 1.64 1.58 Carry 0.77 0.79 0.90 0.70 Value 0.26 0.18 0.31 0.07

Rolling three-year excess returns (%)

20

10

-10

Dec-78

Nov-81

Nov-84

Nov-87

Nov-90
NBER Recessions

Nov-93

Nov-96
Momentum

Nov-99
Carry

Nov-02
Value

Nov-05

Nov-08

Source: Nomura Research, NBER. We define early and late periods of expansions as their first and second calendar halves.
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...while the Performance of Value Trades is Largely Restricted to Periods of Economic Weakness
Annualised information ratios of style-based portfolios in Recessions 1976-2010 Full Sample unconditional Recession periods Early recessions Late recessions Momentum 1.47 1.36 2.13 0.40 Carry 0.77 0.65 1.61 -0.49 Value 0.26 0.68 0.81 0.53

Rolling three-year excess returns (%)

20

10

-10

Dec-78

Nov-81

Nov-84

Nov-87

Nov-90
NBER Recessions

Nov-93

Nov-96

Nov-99
Carry

Nov-02
Value

Nov-05

Nov-08

Momentum

Source: Nomura Research, NBER We define early and late periods of recessions as their first and second calendar halves.
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The Underperformance of Momentum in Late Recessions is Broad-based...

Annualised information ratios of Momentum portfolios by sub-style and by asset class Momentum by Sub-style 1976-2010 Full Sample Expansion periods Recession periods Early recessions Late recessions Price 1.15 1.25 1.04 1.68 0.17 Macro 0.98 1.05 1.30 2.28 0.14 Interest Rates 1.14 1.22 1.28 1.82 0.72 Momentum by Asset Class Credit 0.42 0.36 0.70 1.52 -0.59 Currencies 1.02 1.12 0.75 1.26 0.0 Commodities 0.73 0.67 1.06 1.80 0.15

Source: Nomura Research, NBER We define early and late periods of recessions and expansions as their first and second calendar halves.
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...while that of Carry in Late Recessions is Attributable to Asset Classes Other than Currencies
Annualised information ratios of Carry portfolios by asset class Carry by Asset Class 1976-2010 Full Sample Expansion periods Interest Rates 0.43 0.59 Credit 0.38 0.36 Currencies 0.36 0.43 Commodities 0.50 0.40

Recession periods
Early recessions Late recessions

-0.08
0.10 -0.35

0.46
1.92 -1.31

0.06
-0.80 1.63

1.01
1.93 -0.14

Source: Nomura Research, NBER We define early and late periods of recessions and expansions as their first and second calendar halves.
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Regimes of Monetary Easing are Favourable for Value Investments

1976-2010 Monetary Tightening regime Average quarterly excess return (bp) Annualised information ratio Average quarterly excess return (bp) Monetary Easing regime Annualised information ratio

Momentum 92 1.84 71 1.00

Carry 54 1.02 35 0.67

Value -2 -0.05 49 1.07

Source: Nomura Research, Bloomberg Note: We divide the history into three equally sized buckets based on the average of normalised quarterly changes in policy rates across the G-7 economies. We then present the average same-quarter excess returns and information ratios of the investment strategies based on Momentum, Carry and Value styles in the top and bottom buckets.
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These Macro Properties are Reflected in their Correlation with Bond Markets...
Correlations between style-based portfolios and US Treasury 1-10yr Index Excess Returns Momentum Full Sample Correlation (1976-2010) Median of rolling 5-year correlations 1981-2010 1990-2010 1999-2010 43% 15% 51% 53% -26% 46% -15% -19% -6% -11% -36% -32% 28% Carry -26% Value -6%

2007-2010

Source: Nomura Research, Bloomberg Correlations have been computed using quarterly excess returns. Excess returns of the US Treasury index are over cash.

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... And with Equity Markets

Correlations between style-based portfolios and S&P 500 Excess Returns Momentum Full Sample Correlation (1976-2010) Median of rolling 5-year correlations 1981-2010 1990-2010 1999-2010 -20% 15% -43% -43% 6% -23% 14% 14% -1% 11% 27% 16% -28% Carry -2% Value 11%

2007-2010

Source: Nomura Research, Bloomberg Correlations have been computed using quarterly excess returns. Excess returns of the S&P 500 index are over cash.

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In Periods of Heightened Investor Risk Aversion Momentum Outperforms while Value Underperforms

1986-2010 Average quarterly excess return (bp) Low risk aversion Annualised information ratio Average quarterly excess return (bp) High risk aversion Annualised information ratio

Momentum 29 0.61 117 1.57

Carry 17 0.37 29 0.42

Value 33 0.78 -7 -0.08

Source: Nomura Research, Bloomberg Note: We divide the history into three equally sized buckets based on the quarterly changes in the VXO Index. We then present the average same-quarter excess returns and information ratios of the investment strategies based on Momentum, Carry and Value styles in the top and bottom buckets.
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This Pattern in Observed in Regimes of Tightening Credit Conditions as Well

1976-2010 Average quarterly excess return (bp) Credit Easing Annualised information ratio Average quarterly excess return (bp) Credit Tightening Annualised information ratio

Momentum 66 0.93 129 2.00

Carry 29 0.56 34 0.54

Value 24 0.54 3 0.04

Source: Nomura Research, Bloomberg Note: We divide the history into three equally sized buckets based on the quarterly changes in the spread between 3 month Commercial Paper and 3 month treasury bills. We then present the average same-quarter excess returns and information ratios of the investment strategies based on Momentum, Carry and Value styles in the top and bottom buckets.
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How do Styles in Fixed Income Compare with those in Equity Markets?

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The Evidence for Persistence is Stronger than Reversion to Fair Value in Equity Styles as well
Performance of Equity investment styles: 1976 2010
Equity Momentum 1976-2010 Average annual excess returns (%) Annualised information ratio Skew Hit Ratio(1) 1990-2010 Average annual excess returns (%) 14.0 -0.6 7.9 15.5 0.74 -0.75 64% 0.0 0.00 -0.01 50% 3.1 0.16 0.20 53% Equity Carry Equity Value

Annualised information ratio

Skew Hit Ratio(1)

0.62
-0.77 62%

-0.03
0.23 49%

0.39
0.58 56%

Source: Nomura Research, Kenneth French Data Library Data for US Equities alone. Performance shown is that of volatility-adjusted strategies before transactions costs. Equity Carry : Buy top 30% stocks by Dividend/Price and sell bottom 30%. Equity Value : Buy bottom 30% stocks by prior long term return and sell the top 30%.
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Performance of Equity Styles is not Highly Correlated with that of Fixed Income Styles...
Correlations between style-based portfolios in Equities and Fixed Income Momentum Full Sample Correlation (1976-2010) Median of 5-year rolling correlations 1981-2010 1990-2010 1999-2010 13% 16% 13% -2% -8% -21% -4% -15% -9% 14% Carry -4% Value -5%

2007-2010

21%

-19%

-5%

Source: Nomura Research, Kenneth French Data Library

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...but their Macro Properties are Somewhat Similar

Annualised information ratios of investment styles in Equities Equity Carry 0.93 -1.53 0.36 -0.30 0.00 Equity Value 0.70 0.52 0.13 -0.05 0.16

1976-2010 Early recessions Recession period Late recessions Early expansions Expansion period Mature expansions Full Sample

Equity Momentum 0.77 -0.70 0.91 1.02 0.74

Source: Nomura Research, NBER, Kenneth French Data Library Note: We define early and late periods of recessions and expansions as the first and second calendar halves respectively, of such periods
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How have Style-based Investments Performed Recently?

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It is Well-known that Equity Momentum Outperformed in 2007-08 while Value did so in 2009
Recent performance of style-based investment strategies: 2007-2009 (%, p.a.) 2007 2008 2009 Equity Momentum 50.1 30.5 -62.3 Equity Carry -19.8 26.2 -21.2 Equity Value -48.1 7.4 5.1

Average annual excess returns (%) Annualised volatility (%)

15.5 21.1

0.0 18.8

3.1 19.8

Source: Nomura Research, Kenneth French Data Library Equity Carry : Buy top 30% stocks by Dividend/Price and sell bottom 30%. Equity Value : Buy bottom 30% stocks by prior long term return and sell the top 30%.

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Fixed Income Styles Exhibited a Similar Pattern During the Recent Crisis
Recent performance of style-based investment strategies: 2007-2009 (%, p.a.) 2007 2008 2009 Momentum 3.3 13.9 -0.7 Carry 1.5 2.8 -0.8 Value -2.8 -2.2 3.2

Average annual excess returns (%) Annualised volatility

3.3 2.2

1.4 1.9

0.5 2.0

Source: Nomura Research

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Conclusions

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Conclusions
We classify investment styles in Fixed Income markets into those based on (a) Momentum, (b) Carry and (c) Reversion to fair value In the long historical sample, we find that the performance of Momentum and Carry is robust while that of Value is relatively weaker Momentum and Carry trades perform well in Early recessions while Value does so in Late Recessions Similar unconditional and macro properties of investment styles are observed in the equity markets as well

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