The strategy invests in US Municipal bonds, using Kalman filtering or Ridge regression to evaluate spreads. Bonds are bought or sold based on predicted spreads, with monthly rebalancing and random adjustments.
ASSET CLASS: bonds | REGION: United States | FREQUENCY:
Daily | MARKET: bonds | KEYWORD: Municipal Bond
I. STRATEGY IN A NUTSHELL
US municipal bonds are evaluated against predicted spreads using Kalman filtering or Ridge regression. Bonds trading cheaper than predicted spreads are bought. The portfolio is partially rebalanced monthly (25%).
II. ECONOMIC RATIONALE
The strategy exploits mispricing between actual and model-predicted spreads. Using bond characteristics and advanced models improves pricing accuracy, allowing systematic identification of undervalued municipal bonds.
III. SOURCE PAPER
Systematic Pricing and Trading of Municipal Bonds [Click to Open PDF]
Petter N. Kolm, New York University (NYU) – Courant Institute of Mathematical Sciences; Sudar Purushothaman, Foundation Credit
<Abstract>
In this article, the authors propose a systematic approach for pricing and trading municipal bonds, leveraging the feature-rich information available at the individual bond level. Based on the proposed pricing framework, they estimate several models using ridge regression and Kalman filtering. In their empirical work, they show that the models compare favorably in pricing accuracy to those available in the literature. Additionally, the models are able to quickly adapt to changing market conditions. Incorporating the pricing models into relative value trading strategies, the authors demonstrate that the resulting portfolios generate significant excess returns and positive alpha relative to the Vanguard Long-Term Tax-Exempt Fund (VWLTX), one of the largest mutual funds in the municipal space.
IV. BACKTEST PERFORMANCE
| Annualised Return | 2.06% |
| Volatility | 1.38% |
| Beta | N/A |
| Sharpe Ratio | 1.49 |
| Sortino Ratio | N/A |
| Maximum Drawdown | N/A |
| Win Rate | N/A |
