Update of Credit as a Tactical Asset Allocation Signal

Do credit portfolio managers adjust their portfolios more expeditiously than equity managers, thereby offering a means to time the equity market? In his August 2021 paper entitled “Credit-Informed Tactical Asset Allocation – 10 Years On”, David Klein updates and enhances the strategy presented in his paper of June 2011 (see “Credit as a Tactical Asset Allocation Signal”). The strategy holds stocks (short-term Treasuries) when stocks appear undervalued (overvalued) relative to corporate bonds based on data from a rolling 6-month historical interval. His proxy for corporate bonds is the ICE BofA Single-B US High Yield Index Option-Adjusted Spread (converted to a default probability) and for stocks is the Russell 2000 Index (with dividends). He hypothesizes that stock prices tend to fall when credit spread widens, and small capitalization stocks are more sensitive to credit conditions than large capitalization stocks. Two enhancements to the original strategy are: (1) shorten the lookback from six to three months; and (2) increase the equity allocation by adding a premium to equity values. A third enhancement is taking a 120% long position in stocks when they are undervalued and a 20% short position in stocks when they are overvalued (with 2% estimated annual costs for implementation). Updating and enhancing this strategy with 10 years of new daily data through June 2021, he finds that:

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