Day Hagan Research Update




Bonds tell a different story than stocks. “Don’t fight the tape” remains prudent for longer-term allocation.


Neil Leeson


June 9, 2016


Most financial news outlets, print and TV, focus on the stock market and corporations. I would estimate that a mere 10 percent of the financial news I see come across Twitter, Bloomberg and CNBC during the day is about fixed income. And of that 10 percent, most of it is about yields and their relationship with stocks.

Bonds are boring. They are used for income, long-term core holdings and diversification; they aren’t really tradeable, as the story goes. That’s where exchange traded products (ETPs) come in. There are over 250 fixed-income, long-only, non-leveraged ETPs traded on U.S. exchanges with total assets near $400 billion. Before ETPs, most investors got their bond exposure through mutual funds or individual issues, neither of which were good vehicles for shorter-term allocation or market analysis.


The bulk of ETP fixed-income assets are parked in the aggregate and longer-term U.S. Treasury funds. AGG, the iShares Core U.S. Aggregate Bond ETF, and BND, the Vanguard Total Bond Market ETF, another aggregate fund, have nearly $70 billion in assets between them. Over 50 fixed-income ETPs have greater than $1 billion in total assets; plenty of size and variety for the average investor/trader.

The best performing domestic fixed-income fund this year has been ZROZ, the PIMCO 25+ Year Zero Coupon U.S. Treasury Index fund, which has gained 17.3 percent, over 3½ times the S&P 500. Boring? Hardly. The fund’s standard deviation of returns is higher than that of the S&P 500. This isn’t an anomaly specific to ZROZ. Many fixed-income funds have been more volatile this year than composite stock market ETFs like SPY.

As shown below, the bulk of ZROZ’s outperformance was early in the year when stocks were in correction mode. Since then, there hasn’t been any real apparent relative strength.

PIMCO 25+ Year Zero Coupon U.S. Treasury Index

ZROZ is a pretty vanilla fund that holds longer-dated STRIPS (Separate Trading of Registered Interest and Principal Security). These are debt securities that are created through the process of coupon stripping. They are Treasury bonds where the principal has been stripped from the coupon.

When you run a rolling correlation between ZROZ and SPY, you will find the two have been inversely correlated for a majority of the time over the past two years. But investors should keep in mind that there are periods where ZROZ moves in the same direction as the stock market (below).

63-Day Correlation of 5-Day gains of SPY and ZROZ

From a diversification standpoint though, ZROZ is still one of the better options when you look at two other popular long-dated Treasury funds, TLT and TIP. As shown below, the correlation between TIP, the inflation-protected fund, and SPY has been positive of late, and TLT’s correlation is slightly less than ZROZ’s with SPY. But essentially, TLT and TIP should, and do, move together (63-day correlation of 5-day returns).

63-Day Correclation of 5-Day gains of TLT and ZROZ

In the correlation matrix shown above, I included UUP, the bullish dollar index fund. Like stocks, Treasury correlation with the dollar currently stands negative. However, it can turn positive, which illustrates the axiom of acting based on “what is happening, and not what should be happening.” Correlations should be used as general guides only. Given the trends over the past five years, it would appear that we are at extremes that may be set to reverse.

63-day Correlation of 5-day gains of TIP and UUP


While ZROZ and TLT have shown more volatility than SPY this year, TIP has not. TIP, the iShares Barclays TIPS Bond ETF, holds longer-dated, inflation-protected U.S. Treasuries and has gained 5.5 percent on the year compared to the 11.4 percent gain for TLT, the comparable non-inflation hedged fund. STPZ, the shorter-dated PIMCO 1-5 year U.S. TIPS ETF, has realized even less volatility this year while still gaining 2.5 percent. On a risk-adjusted basis TIP has a slight advantage over TLT and a larger advantage over STPZ.

As shown below, on a relative basis (bottom clip) TIPs are undervalued relative to real yields. The spread has narrowed recently, but inflation-protected bonds still hold the advantage.

10-Year TIPS Yields vs Expected Real Yields

On a nominal and risk-adjusted basis, gold, as measured by GLD, has been the real winner this year, gaining over 18.8 percent. As shown, the correlation between GLD and TIP has risen substantially since mid-April, suggesting that investors are ratcheting up their inflation expectations and defensive posture.

63-day Correlation of 5-day gains of GLD and TIP

However, TIP is somewhat overbought on a shorter-term basis, and net outflows this month suggest that caution is warranted.

iShares TIPS Bond ETF (TIP)

While there are net outflows from TIP, there have been net inflows to GLD. In most situations, you want to “go with the flow until it reaches an extreme and starts to reverse.”

SPDR Gold Trust (GLD)

Treasuries, TIPs and gold are all moving for the same reasons: diversification, inflation hedge and safety/defense. If investor sentiment changes and starts to embrace more “risk-on” strategies, these types of assets may fall hard. But for now, our composite models suggest that the crowd is just not ready to get fully invested in domestic and global equities. For those who hold these “defensive assets,” be mindful of the relative volatility, because TLT and GLD are exhibiting higher volatility than a composite of domestic large-cap stocks (SPY). If their runs end, it could be swift and painful. Therefore, I would consider adding some TIP exposure on pullbacks and consider more aggressive allocation if flows turn back positive.

Have a wonderful week,

Neil Leeson
Day Hagan Asset Management Investment Committee

— Written 05-31-2016

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