Betting Against Beta (and Gamma) Using Government Bonds

Purportedly consistent with “risk parity” (RP) asset allocation, recent studies document compelling “low risk” trading strategies that exploit a persistently negative relation between Sharpe ratios (SRs) and maturity along the U.S. Treasury (UST) term structure. This paper extends this evidence on betting against beta with government bonds (BABgov) in four respects. First, out-of-sample tests suggest that excess returns may have waned somewhat recently and that the pattern seems most pronounced for USTs given data on ten other previously unexamined government bond markets. Second, BABgov appears robust when hedged ex-ante against covariance with equities and thereby does not resemble selling volatility, but these results nonetheless belie a possible tension rather than consistency between leverage constraints and low-risk investing: namely, that investors bid longer-dated UST prices higher (lower) under BAB (RP). Third, the fact that Gaussian affine term structure models of USTs also imply an inverted SR schedule suggests that investors cannot, in fact, realize abnormal returns if they are fully hedged to the underlying model factors, and BABgov excess returns are indeed not robust to ex-ante constraints on exposure to the yield curve's principal components. Fourth, some evidence suggests that previous BABgov results reflect coskew preferences, alternative BABgov strategies hedged to coskew risks ex-ante forgo substantial returns, and there is no indication that investors can earn excess returns betting against gamma. However, the sign of investors' coskew preferences in government bond markets remains ambiguous