When Backtests Fail
Let’s say you’re building a diversified portfolio and want to include European high yield bonds in the mix. What are you plugging in for an estimated return today?
If you’re like most investors, you’ll look to a backtest to provide the answer, asking the following question: what have the returns been historically?
With data going back to January 1998, European junk bonds have delivered an annualized return of 7.1% (note: total return, using BofA Merrill Lynch Euro High Yield Index). Not too shabby, especially in the era of negative interest rates. We’ll just plug that number in and start collecting on the 7.1%.
Will that work out as planned? Probably not.
Historically, there’s a pretty close relationship between the starting yield and forward returns. In general, the higher the starting yield, the higher the future returns, and vice versa.
In late 2008 when European junk bond yields peaked at over 25%. Investors purchasing those bonds would earn annualized returns over 20% in the next 5 years.
What does this imply for today’s market?
With European junk bond yields hitting an all-time low this week of 2.15% (lower than the yield on 10-year Treasury Bonds), we should expect much lower future returns.
Just how low remains to be seen, as there is no historical precedent for 2% junk bond yields. But barring a change in bond math, it will be nearly impossible for European junk bonds to approach their historical average return of 7.1%. If spreads should widen and defaults pickup, investors would likely be facing negative returns.
When markets hit extremes, backtests are doomed to fail. You can’t assume the future will look anything like the past when the present doesn’t not look anything like the past.
This was true for the Nikkei in 1989, the Nasdaq in 2000, and European junk bonds today. Caveat emptor.
To sign up for our free newsletter, click here.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. Charlie holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and also holds the Certified Public Accountant (CPA) certificate.
In 2017, Charlie was named the StockTwits Person of the Year. He is a frequent contributor to Yahoo Finance and has been interviewed on CNBC, Bloomberg, and Fox Business.
You can follow Charlie on twitter here.
Comments are closed.