Portfolio Design

Advanced concepts in stock investment portfolio design.  Fundamentals, technical analysis and many other related topics are discussed.

Time The Stock Market Using Credit Spreads

 

Some time ago, I wrote a post about Timing The Market With Perceived Credit Risk, the idea that a TED Spread of 0.5% or higher was considered to be an elevated risk of bank loan default, while any Spread under 0.5% is considered to be normal. Another indicator for credit risk is the spread between corporate bonds and treasuries.


One particularly useful index is the Bank of America Merrill Lynch US Corporate BBB Option-Adjusted Spread index, which indicates the spreads between BBB rated corporate bonds (LQD) and U.S. long term Treasury Bonds (TLT). The spread measures how much more a business pays to borrow money than the government does. As you can see from the chart below, the index (spread) spikes in times of recession. 

Bank of America Merrill Lynch US Corporate BBB Option-Adjusted Spread index plotted over top of the S&P 500 index from 1997 to present

"Typically, the higher risk a bond or asset class carries, the higher its yield spread. When an investment is viewed as low-risk, investors do not require a large yield for tying up their cash. However, if an investment is viewed as higher risk, investors demand adequate compensation through a higher yield spread in exchange for taking on the risk of their principal declining. For example, a bond issued by a large, financially healthy company typically trades at a relatively low spread in relation to U.S. Treasuries." - Yield Spread according to Wikipedia.

A market timer can be built by comparing the Bank of America Merrill Lynch US Corporate BBB Option-Adjusted Spread index against its long term average. The buy rules below illustrate the timer in action using financial analysis tools provided by Portfolio123

Simple market timing rules for market timer simuylation in Portfolio123

These rules describe a system where the investor holds the S&P 500 ETF (Symbol: SPY) when the index is below the 4 year Simple Moving Average (SMA). When the index is above the SMA, the investor moves to cash. The simulated results from 1999 to present are shown below

Simulation backtest results - equity curve

Simulation backtest statistics

The results show that this market timer would have kept the investor out of major stock market downturns. Keep in mind that this simulation was done with the benefit of hindsight and may not bring future rewards.  However, it can be used in conjunction with other indicators to possibly enhance trading profits.