Safeguard

I want you
I need you
But there ain’t no way I’m ever gonna love you
Now don’t be sad
‘Cause two out of three ain’t bad

Two Out of Three Ain’t Bad, song by Meat Loaf

Investment Objective

When thinking about investments, we typically think about maximizing gains, and longtime horizons. But there are situations with very different characteristics. The Safeguard strategy has the following objective:

• Very conservative investment with low volatility
• Very risk-averse, with only minimal downside risk
• Short break-even period, suitable for short-term investments
• Beat the aggregate bond market index without adding undue risk

With these characteristics, Safeguard is typically used in the following scenarios:

• As a temporary short-term investment, holding your capital before a major financial event, during times of crises, or while figuring out higher yielding alternatives
• As a component of a strategy blend, effectively taming down the blend, and reducing volatility
• As a longer-term investment for very risk-averse investors

Simply put, Safeguard is the strategy you didn’t know you would need. But once it is in your arsenal, there is no shortage of situations, in which it makes an excellent choice.

Strategy Construction

Top-Level Architecture

As a starting point for Safeguard, I have chosen Richard Heine’s Bond Trading Model. This model was first published in 1995, possibly inspired by a period of rising interest rates just before that time. I like how the strategy not only considers the asset’s price action, but also at multiple macro-economic indicators and their trend direction.

Specifically, we take a majority votes on the following criteria:

These rules are not random but rooted in the way our economy works. Bond price valuation dictates that bond prices have to come down when yields are going up. The utility sector, including the power grid, is highly leveraged, and intertwined with commodity pricing. Consequently, the utility sector and commodity pricing may act as canaries to the bond market.

From my own experience, having spent a lot developing bond trading strategies, neither momentum, nor trend work well on these assets. Heine’s Bond Trading Model with its slightly more informed approach is indeed one of the very few jewels out there.

Emergency Brake

The strategy works beautifully, right out of the box. However, in order to manage assets with higher volatility, I added an emergency brake mechanism.

If the Ulcer Index, calculated from the asset’s typical price, exceeds its annual average by more than one standard deviation away, we disqualify the asset.

This additional rule really aims at junk bonds and 20+ year Treasuries, but for symmetry reasons we apply it to all assets.

Asset Selection

Unfortunately, as described, the strategy only trades a single asset. I therefore expanded upon the original strategy, and added the ability to trade Treasuries of various duration, plus corporate and junk bonds.

Safeguard trades the following assets:

The assets in the table above are sorted by priority. For each of these assets, we individually calculate Heine’s Bond Trading Model. Then, we start assigning capital to them, up to the maximum exposure, and until our capital is fully assigned.

Corporate bonds, as well as Treasuries with long maturities can be quite volatile, so we limit exposure to these assets, and enforce a little bit of diversification.

Strategy Results

Compared to an investment in the aggregate bond market, Safeguard adds tremendous value. The Monte Carlo simulation shows how the dependable returns at the 5th percentile improve by about 2%, while at the same time also increasing the average returns. Considering that the rule-of-thumb withdrawal rate from retirement is about 4%, this is a substantial improvement.

For shorter-term investors, it is comforting to know that the break-even period is reduced to about one year. And risk-averse investors will sure appreciate how Safeguard reduces expected recession drawdowns, as well as the time to recover from such losses.

The cumulative returns chart shows how this has panned out in the past. Safeguard has done a good job in matching or outperforming its passive benchmark, with the early 2000s being the only exception. Further, the strategy has done an excellent job in reducing drawdowns, especially in the early 1980s, and in 2022/23.

The rolling returns show how Safeguard was well able to avoid periods of negative returns. Further, the tracking chart confirms how the strategy was able to outperform its benchmark over the decades.

Conclusion

In summary, Safeguard is a very conservative strategy with low volatility, offering superior returns at the 5th percentile. With such characteristics, it is an excellent choice for Investing Toward a Goal and the Investing for Income scenarios, especially in conjunction with short investment periods, but also for very risk-averse investors.

As hinted in the rock’n’roll quote above, Safeguard is certainly not a strategy to brag about. It is a bit of an underdog, the strategy you didn’t know you needed. But it nonetheless delivers significant value, and I will illustrate that in my chapter about strategy blends.