By Nick Maroutsos
Nick Maroutsos, Co-Head of Global Bonds, explains why understanding correlation is important to achieving diversification.
Economist Harry Markowitz is credited with coining the phrase “diversification is the only free lunch in investing.” What this really means is that, by combining asset classes and strategies with a positive expected return - but that tend to zig and zag at different times - we can potentially reduce overall volatility and improve risk-adjusted returns.
Correlation is a measure of the zig and zag, so it follows that if a portfolio is to be well-diversified, it should contain securities with a low correlation (i.e., tend to move in different directions). Yet, assets do not always behave as expected, meaning investors should have a broader consideration of the variables that can influence correlation.
Large numbers alone do not necessarily equate to diversification. For example, the Bloomberg Barclays Global Aggregate Bond Index consists of nearly 23,000 investment-grade government, corporate and securitized fixed-rate bonds (as of 3/31/19). However, Index allocation is determined by levels of outstanding debt, with the largest issuers often representing substantial weightings. So, with government bonds making up a significant portion of the Index, interest rate moves are a dominant risk factor, while businesses with improving fundamentals - which may be poised for ratings upgrades - are often underrepresented.
Investors expect government bonds and equities to have low correlation. That’s because these assets typically have different influencing factors: interest rates primarily drive bond prices, while equity prices may be driven by corporate earnings or growth prospects.
Consider what normally happens during a business cycle: When economic conditions are deteriorating, central banks often lower interest rates, sending bond prices up. In contrast, equities may decline in light of weak earnings conditions (though stocks can eventually respond positively to low interest rates). Later, when the economy is strong, equities normally do well. At this point, central banks typically start to raise rates (to try to prevent the economy from overheating), which hurts bonds, since they are directly sensitive to rate changes. Equities can also decline, but typically only after the market begins pricing in expectations of an economic slowdown.
Ultimately, though, the correlation between equities and bonds depends on inflation and market volatility. To understand the changing nature of correlation, it helps to think about different economic scenarios.
For example, the negative correlation between government bonds and equities, which has largely persisted for the last 25 years, has broken down during times of shock. We saw this in 2013, when the so-called taper tantrum pressured housing markets, and again in early 2018, when there was an inflation shock. On both occasions, investors demanded higher yields on U.S. government bonds, which caused bond prices to fall, yet at the same time the equity market tumbled (spooked by potentially higher financing costs). This environment resulted in rising rates and a widening gap between yields on Treasuries and lower-quality credits, delivering a double whammy to fixed-income portfolios.
Source: Thomson Reuters Datastream, Janus Henderson Investors, S&P 500 Total Return Index, ICE BofAML 7-10-year U.S. Treasury Total Return Index. Three-month moving average of one-month correlation using daily returns in U.S. dollars. Moving average is centered to be more coincident with events.
Why should a fixed-income investor care about equities or other asset classes? First, it’s important to remember that capital markets do not exist in isolation. Strong equity markets make equity financing easier, potentially increasing the equity weighting in the debt/equity ratio of a company. This is important as we move down the credit spectrum, where lower-grade corporate bonds are more sensitive to corporate conditions.
Second, policymakers care about equity markets, so it’s useful to look beyond fixed income. For example, between 1987 and 2006, Alan Greenspan as Federal Reserve (Fed) chairman set a precedent that the Fed would intervene to support the economy (and by extension, stocks) in times of crisis. More recently, following the equity market sell-off in late 2018, we saw the Fed in early January 2019 backpedal on its intention to raise rates several times this year.
Correlation and Diversification
It might seem that a fixed-income portfolio - being focused on one asset class - would struggle to generate diversification, but this belies the diverse nature of the asset class. If we look under the hood, many sub-sectors of the fixed-income market often perform differently over the same period. For example, floating rate notes or index-linked bonds - where coupons rise with rising interest rates or inflation - perform differently than fixed-rate bonds. Similarly, divergence can occur between different countries: In 2018, holders of Australian government debt achieved a 5.3% return in local currency terms, whereas Italian government bond holders suffered a -1.4% return.1
Having the freedom to move between different geographies allows an unconstrained investor the opportunity to take advantage of differences in the yield curves between countries. The chart below demonstrates how, over just two years, yield curves can move in very different directions. The U.S. yield curve has flattened as the U.S. has pursued monetary tightening, while the yield curves in the eurozone have remained steep, reflecting negative rates. Meanwhile, in New Zealand, rates have fallen significantly from levels that reflected an optimistic assessment of the economy.
Source: Bloomberg, country sovereign curves, euro swap used as eurozone proxy, as of 3/31/17 and 3/31/19. Yields may vary and are not guaranteed.
Gauging where a country might be in its economic and credit cycle, therefore, has important implications for where one might want to be invested in terms of accepting or mitigating interest rate risk or credit risk. Broader cycles incorporate mini-cycles, so there can be periods during which yields may temporarily rise or fall, or credit spreads widen or narrow, independently of what might be expected of the cycle. Often this is triggered by shocks, including unexpected economic data, politics, central bank policy surprises or idiosyncrasies associated with an issuer.
Taking a global active approach to asset allocation may help investors maximize opportunities for diversification by seeking securities and strategies with low correlation to each other, while tactically exploiting situations as they arise.
1 Source: Thomson Reuters Datastream, 12/31/17 to 12/31/18, ICE BofAML Australia Government Index, ICE BofAML Italy Government Index, total return in local currencies.
Investing involves market risk; principal loss is possible. Equity and fixed-income securities are subject to various risks including, but not limited to, market risk, credit risk and interest rate risk.
Fixed-income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Disclaimer: Please consider the charges, risks, expenses and investment objectives carefully before investing. Please see a prospectus or, if available, a summary prospectus containing this and other information. Read it carefully before you invest or send money.
The opinions and views expressed are as of the date published and are subject to change without notice. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes and are not an indication of trading intent. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. Janus Henderson Group plc through its subsidiaries may manage investment products with a financial interest in securities mentioned herein and any comments should not be construed as a reflection on the past or future profitability. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.
Janus Henderson Investors ©2001-2019. All rights reserved.