By Arif Husain
Bond market sectors are becoming increasingly correlated—and this is bad news for fixed income investors seeking to manage risk through sector diversification.
In the past, different types of bond sectors—such as Treasuries and credit – have displayed low correlation to each other, making it possible to diversify by investing across them.This will mean abandoning tried-and-tested strategies in favour of bolder approaches that embrace sectors and instruments which may have previously been considered too risky or unconventional.
Long-term patterns have emerged
Using monthly return correlations over a three-year time horizon, the correlation between US Treasuries and US investment grade corporates was less than 0.5 in March 2008 and then fell to below 0.1 in March 2011 before beginning to rise sharply in 2013. It currently stands at just under 0.9 – almost perfectly correlated.
And it is not just in the US that correlations between sovereign bonds and credit are rising. The pattern is the same in Europe, where the correlation between government bonds and investment grade credit also spiked dramatically in the autumn of 2013 before settling at its current level of just over 0.8.
What is more, rising correlations are not just confined to different types of bond instruments: Correlation levels between bonds and currencies are also rising.
QE wiping out differentiation
The primary reason for rising correlations over the past few years has been central bank quantitative easing (QE), which has tightened credit spreads to such an extent that quality differentiation has been all but lost.
It is evident from the data that the US bond market is a few years ahead of the European market. This makes sense when we consider the respective stages in the two regions’ economic cycles.
The higher correlations currently seen in the US could occur in Europe within the next few years, which will have major implications for bond investors whose strategies involve diversifying across government bonds and credit.
The end of the bond barbell
One approach under threat is the barbell strategy, which can take different forms but typically divides the portfolio into two heavily concentrated buckets of lower- and higher-risk assets.
For a barbell strategy to succeed over the long term, however, the two sides of the barbell need to maintain low correlation to each other. When two sides of a barbell are highly correlated – as is the case at present – it ceases to be an effective way of managing risk and becomes instead a highly risky strategy.
A more flexible approach is likely to deliver better results over the long term – one that considers the full spectrum of the fixed income universe, in particular regions and countries that are less correlated to major markets.
Time to look further afield
One way to accomplish this is to divide fixed income holdings into three core components: core stable positions, return-seeking positions, and defensive positions.
Core stable positions are those with small, but steady, income or gain potential and a low risk profile, and may include high-conviction positions in markets with a low fat-tail risk, as well as shorter-dated investment-grade corporate products. For example, we have been overweight specific Asian local markets, such as South Korea and Thailand. Asia is fast moving into a new wave of central bank easing, offering attractive opportunities for bond investors. Closer to home, the recent correction in periphery country spreads allowed us to reinstate a position in Portugal.
Return-seeking positions include high-conviction investments that have strong potential for capital gains or high income characteristics. They may include locally denominated emerging market debt and select high yield names.
We have increased recently our allocation to long-maturity local Mexico bonds, as prospects for inflation remain subdued. At the same time, we have added to selected number of European high yield names. These offer attractive coupons and a relatively short maturity, thus avoiding unnecessary marked to market price volatility.
Defensive positions are typically those are unlikely to perform unless in a risk-averse environment, such as inflation-linked products and short positions in vulnerable currencies and sectors. For example, we made a contrarian move to buy the Japanese yen during the past 12 months. While the yen is likely to depreciate over the medium term, it often acts as a safe haven currency at time of market stress, and therefore provides a decent insurance policy against risk positions.
Towards the end of January, we also decided to short the Turkish lira to finance a long position in the Russian rouble, which is a good way to remain Emerging Market currency neutral, while expressing a preference for the Russian rouble from a fundamental perspective.
Arif Husain is head of international fixed income at T. Rowe Price.
