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.
Arif Husain is head of international fixed income at T. Rowe Price.
