Indeed, an element of complacency has crept into portfolio positioning: Many investors still feel comfortable being heavily exposed to credit and illiquidity risk in their search for yield, presumably because they believe duration exposure can cushion any sell-off in corporate bonds.
A reversal could drag them down
As shown below, that has not happened.
German Bund yields and European credit spreads have been positively correlated since 2012
Correlation has remained positive as yields and spreads have moved up, just as it was positive on the way down.
And why should we be surprised? This is partly to do with the asymmetry of the risk associated with core government bonds: With 10-year bund yields near zero, it has simply become difficult for them to go much lower.
More importantly, it’s the predictable result of the move toward the reversal of QE forces – what had been inflating these assets is now deflating them.
When central banks are buying all the government bonds, to get duration investors have to buy long-dated credit assets; now, to sell duration they have to sell credit assets. That is why we believe that, while this might not last forever, current high correlations could persist for some time.
Flexibility can help diversify bond risk
Of course, all the while prices were going up, investors could afford to turn a blind eye to a lack of diversification. It’s not so much fun when prices start going down.
We still think that credit risk is a good risk to take, particularly relative to interest rate risk.
But pursuing a flexible strategy can help to do this in a targeted way. A long/short approach, for example, can facilitate relative value trades and cut exposure to market risk. Derivatives can be used to strip out duration from corporate bond positions.
For short-term bouts of risk aversion, perhaps call options on bunds or treasuries can provide exposure to a potential drop in yields without exposure to losses should they keep trending upwards.
One thing seems clear: Reliance on the old, pre-2012 correlations to diversify fixed income portfolios is risky.
Those correlations disappeared three years ago, and the past few weeks have finally made people sit up and notice.
