Strategic Lending Solutions
In the world of investment, a tactical credit strategy has been gaining traction. This strategy, aptly named tactical credit, dynamically allocates between high yield corporate bonds and core fixed income (or short-to-medium-term U.S. Treasuries) based on a momentum-driven signal.
Performance Characteristics
This strategy aims to enhance risk-adjusted returns by capitalising on prevailing market trends and sentiment. High yield bonds offer attractive absolute yields but come with higher default risk and volatility than core fixed income. By utilising momentum to switch between them, the strategy can reduce drawdowns by shifting towards core bonds when high yield momentum fades, thereby improving risk-adjusted returns and lowering price volatility.
Short-duration bonds within the high yield space tend to have lower price volatility and smaller drawdowns than broader high yield or investment grade corporates, a factor that tactical momentum strategies often exploit to balance yield and risk.
Driving Factors
The strategy primarily relies on momentum signals that identify trends in returns or spreads, enabling the fund to tactically overweight either high yield or core corporates depending on which asset class shows stronger positive relative momentum. Shifts in macroeconomic factors, especially inflation and corporate earnings outlooks, strongly influence both high yield and core bond markets. Tactical momentum models incorporate these regimes, allocating risk-seeking in favorable environments supportive of corporate earnings and shifting defensive when uncertainty or inflation concerns rise.
Risks and Limitations
Momentum strategies can suffer in volatile or range-bound markets due to frequent whipsaws, leading to higher turnover, transaction costs, and potential tax consequences. Rapid trend reversals can cause losses if the model is slow to adjust allocations. Shorter-term horizons (typically 12–18 months) require active management to adapt to changing macro regimes and credit conditions.
Historical Performance
The tactical credit strategy has demonstrated impressive performance over the years. Since the 1990s, the price return of high yield bonds has annualised at -0.8%, a stark contrast to the strategy's performance. The strategy harvested approximately 35,000 basis points from 12/1996 to present by harvesting significant changes in credit spreads.
However, the price return of high yield bonds is volatile, with years like 2008 seeing a price return of -27%. The strategy tends to outperform core bonds during most periods, with the exception of periods of economic stress (e.g. 2000-2002 or 2008).
Capturing price returns due to changes in credit spreads account for approximately 75% of the strategy's total return. The strategy appears to perform best during periods when credit spreads are expanding above their long-term median level (e.g. crisis periods like 2008).
The strategy tends to underperform high yield corporates in most environments, but has historically added significant value in those same periods of economic stress. The strategy predominately benefited from harvesting contracting spreads, as exposure to expanding spreads had a cumulative net zero impact.
Conclusion
In conclusion, the tactical credit strategy offers a compelling approach to enhancing risk-adjusted returns by dynamically capturing market trends in spreads and earnings while managing downside in uncertain environments. Its success depends heavily on the stability of momentum trends, macroeconomic regime shifts, and credit fundamentals such as default rates and yield differentials. The strategy's active returns are generated by the tactical signals and determine value-add beyond a diversified buy-and-hold core.
Investing in the tactical credit strategy involves financing high yield bonds and core fixed income, aiming to capitalize on market trends and sentiment to enhance risk-adjusted returns. This strategy utilizes momentum to balance yield and risk by switching between high yield and core bonds, reducing drawdowns and lowering price volatility.
