When yields were generally falling and spreads tightening, investors could afford to ignore the increasingly positive correlation between core government bonds and credit markets.
Today, we believe that would be misguided.
Back in 2011, as the eurozone crisis raged, European credit spreads widened and the 10-year German bund yield plummeted by nearly 200 basis points over the summer.
As risk appetite evaporated, capital rushed to perceived safe havens.
Fixed income investors could be grateful that their core government bond exposures had cushioned the worst corporate bond losses, and many waited to rebalance.
But then things changed.
There was a brief resumption of ‘normal’ negative correlation during the summer of 2012, when Greece was struggling to form a government. But then European Central Bank president Mario Draghi put an end to that with his promise to do “whatever it takes” to keep the euro intact.
In the three years since, bund yields and credit spreads – whether on corporates or peripheral European sovereigns – have fallen in lockstep. A similar, albeit weaker, pattern has emerged in US bond markets.
QE drove bond prices up
Quantitative easing, clearly, has been a key reason for this new era of credit-treasury market correlation.
Of course, it wasn’t for another three years that the ECB unleashed its current program, but its clear policy commitment, combined with the easing postures of other central banks, helped intensify truly global loosening of monetary conditions.
An intended effect of QE was to encourage buyers of core government bonds to take more risk, which they did, pushing credit spreads tighter and flattening the credit curve as they sought extra yield from both illiquidity and longer duration.
This is a key reason credit spreads chased government bond yields all the way down to their lows in the first quarter of 2015.
Since then, however, investors have struggled to extrapolate the logic of this close relationship to current market conditions.
