During the COVID-19 pandemic, the real economy and capital market suffer a significant impact. To limit economic damage from the pandemic crisis, the Federal Reserve cut rates to zero and lunches a $700 billion quantitative easing(QE) program in March 2020. The super-low rate policy makes the bond market not be a safeguard to market drawdown anymore, and the fast growth of money supply pushes the inflation expectation up. Both situations cause a
great challenge to the portfolio manager. In this report, we use inflation expectation embedded in bond yield to shed some light on bond allocation under different situations.
We use the breakeven inflation rate as the proxy for the market’s inflation expectations. The definition of the breakeven inflation rate is the difference between yields on nominal Treasury securities and on Treasury Inflation-Protected Security (TIP) of comparable maturities. The interpretation of the breakeven rate as an inflation expectation depends on the “Fisher Effect” validness. The Fisher Effect states that the nominal yield is the real yield plus expected inflation. Also, from the d’Amico et al. , it points out that changes in the breakeven rates can largely reflect changes in inflation expectations or the investors’ attitude toward inflation risks. Thus, we consider both the level and change of the breakeven rate in this work.
By incorporating breakeven rate change and breakeven rate level together, we developed a bond rotation strategy, which rotates between long-term Treasury ETF (VGLT), mid-term Treasury ETF (VGIT), and Treasury Inflation-Protected Security ETF (TIP). From 2003-2021/3, with an average of 16.24 transactions per year, this strategy has 9.36% annualized return and 0.87 Sharpe ratio. Compared to the VGLT, the strategy improved 4.33% in annualized return, and compared to the VGIT, the strategy improves 0.18 in Sharpe ratio.
 S.d’Amico, D.H.Kim, M. Wei, Tips from tips: the informational contenet of treasury inflation-protected security prices, Journal of Financial and Quantitative Analysis 53(2018) 395-436
AVP of Quantitative Finance, Gamma Paradigm Research