• Investment Management

Breaking the Curse of Correlation

Why it’s becoming more difficult for bonds to balance out stocks in investment portfolios.

Having a mix of bonds and stocks in portfolios has always been investing 101. The general rule has been that equities go up when economies do better and bonds do better when economies go down. Their low correlation to one another is why they make a perfect pair in a portfolio.

At least, that was the case. In the last 12 months bond markets have been cursed with a higher correlation to equities. According to Morgan Stanley Research, global credit and equity has become more highly correlated, as it has deviated above its long-term average by more than 22% this year1.

 “There's no getting around the fact that when assets are highly correlated it's difficult to construct a diversified portfolio," says Jim Caron, portfolio manager with Morgan Stanley Investment Management. “The increase in correlation is a new dynamic risk factor that investors need to account for in their asset allocation. If you want fixed income to help balance out volatile equity returns, then you need to invest in funds or construct portfolios that seek to reduce this correlation risk."

*Source: The Morgan Stanley Credit-Equity Index is a sub-set of the Morgan Stanley Cross-Asset Correlation Index.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future

In a new white paper Caron explores why bonds are now careening up and down with riskier asset classes, and why they are no longer anchored by their credit strength. He argues there are permanent changes to the way the bond markets work, because of regulations restricting the ability to buy and sell bonds in sizeable amounts, and monetary policy that's whittled yields down to a point where a small selloff can quickly turn returns negative and spark more selling.

“Historically, the value of a fixed- income asset was mainly driven by economic fundamentals, with a smaller component coming from other kinds of risks. Today, the opposite is true," says Caron.

The Dark Arts

Investors demand compensation not just for the risk of a company possibly defaulting, but also for all the other external risks they think could hurt a bond's value. That compensation, or “risk premia" now makes up the bulk of the trading levels corporate bonds trade over risk-free Treasuries, and the compensation for the credit fundamentals,  is much smaller.

That flip, says Caron, is tantamount to letting the dark arts take over the bond markets.

“Some people refer to assessing risk premia as a dark art," says Caron. “It's mysterious and more of an art than a science. Many people value and calculate risk premia differently; each way might be valid, but the results can all vary widely. Changes in risk premia are highly unpredictable and cause higher correlation among asset prices."

One of the biggest risks investors demand compensation for is entrenched illiquidity in the bond markets. Trades that once took two days to clear now take two weeks, says Caron, because regulations have severely restricted the market-making capacity of banks.

Not knowing how to value illiquidity is one of the principle reasons why volatility in the bond market tends to resemble a roller coaster ride. 

Planning for Volatility

“You have to plan your whole investment strategy around volatility,” says Caron. “We've seen that when volatility hits, bond prices have overshot further and for longer periods of time than they used to. So we as an investor don't necessarily buy the first dip. We wait until things get excessively cheap before we go in and buy."

It's also no longer the amount of bonds you have in your portfolio that's the emphasis, but the kind of bonds. Active fund managers like Caron follow barbell strategies, where they have highly liquid but low-yielding bonds at one end, and less liquid but higher-yielding credit securities at the other, which they know they might not be able to sell, but are comfortable holding for a long period of time.

Once these changes are made, correlations can potentially be lowered, without necessarily sacrificing returns, says Caron. “The big thing for end investors to consider is to increase their holding period, and not to go in and out of markets. Remember, the market now tells you nothing about fundamentals and much more about its dysfunctions."

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