By Jon Jonsson
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. 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.
…and a reversal could drag them down
That hasn’t happened. 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.
Jon Jonsson is a senior portfolio manager, global fixed income at Neuberger Berman
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