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Duration Risk Part III

22 May 2017 by Chris Bowie

Following on from our previous duration blogs (Part I and Part II), we received another very interesting follow on question: “If sovereign bonds have a useful negative correlation to equities for multi-asset portfolios, does US credit exhibit similar characteristics, or is it positively correlated? And what happens during periods of spread compression/widening to those correlations?”

Firstly, let’s look at the US HY market versus the S&P 500. As you can see from Chart 1 below, the riskiest sector of credit has a positive, and strong correlation to the S&P. Secondly, just as we found with the UK market in our duration blog Part II, the sovereign bond correlation for US Treasuries vs the S&P is also negative, to a very similar degree from that within the UK.

Chart 1: Rolling 1Yr Correlations to the S&P 500, Source: Bloomberg, BAML, TwentyFour (all charts from 31/12/1999 to 18/05/2017)

In slight contrast to the gilt market however, there have been longer periods with low/no correlation between US Treasuries and the S&P, such as 2003 – early 2007. However, since the onset of the credit crisis later in 2007, correlations have almost always been strongly negative, as you would expect. What has surprised me has been the steady rise in HY vs S&P correlations – this on the face of it appears structural doesn’t it? Has there been a structural rise in financial leverage that could explain this, or is it something else? Certainly a topic for another day.

Moving on, look at Chart 2 below.

Chart 2: Rolling 1Yr Correlations to the S&P 500, Source: Bloomberg, BAML, TwentyFour

Now, when we also include US Investment Grade, we find that the US IG market gives multi-asset managers an almost identical degree of negative correlation to that enjoyed from UST’s. Perhaps not surprisingly, a gap opened up in 2008 during the worst of the credit crisis between US IG and UST’s vs. the S&P. But even then, there remained a strong negative correlation between US IG and the S&P. Plotting the evolution of credit spreads in US IG over that period, explains exactly when the almost identically negative correlations to the S&P from US IG and UST’s adjust a little lower, see chart 3 below.

Chart 3: US Investment Grade spreads to US Treasuries, Source: Bloomberg, BAML, TwentyFour

2008 and 2011 stand out here – where spread volatility picks up significantly, then as you might expect, IG credit correlations to the S&P do increase a little, but remain strongly negative and always within sight of the correlations between Treasuries and the S&P.
So, should multi-asset investors consider using IG credit instead of Treasuries to balance a long equity position and benefit from those negative correlations? Well, perhaps; except in extreme periods of credit volatility (by which I mean 2008), I would say the data does support that view. When you factor in the additional returns that IG consistently delivers versus Treasuries the case becomes stronger, as shown in Chart 4.

Chart 4: US Investment Grade returns versus US Treasuries, Source: Bloomberg, BAML, TwentyFour

Over the period under review, IG has returned some 50% more than UST’s, with highly correlated returns (and therefore negative correlations to the S&P). On an annualised basis, this means a return of 6.06% for IG vs. 4.86% for Treasuries.

120bps additional return every year for a similar negative correlation benefit to equities? Certainly worthy of consideration for multi-asset portfolios.

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