The end of the bond barbell?

Bond market sectors are becoming increasingly correlated—and this is bad news for fixed income investors seeking to manage risk through sector diversification. Using monthly return correlations over a 3yr horizon, the correlation between treasuries and US IG credit was less than 0.5 in March 2008 and below 0.1 in March 2011, before rising sharply in 2013. It currently stands at just under 0.9 – almost perfectly correlated.

The pattern is the same in Europe, where the correlation between government bonds and IG credit also spiked in the autumn of 2013 before settling at its current level of just over 0.8. Correlation levels between bonds and currencies are also rising. The primary reason for rising correlations has been QE, which has tightened spreads to such an extent the quality differentiation has been all but lost. One approach under threat is the barbell, which typically divides a portfolio into two concentrated buckets of lower and higher-risk assets. For a barbell to succeed, the two sides need to maintain low correlation. When two sides are highly correlated – as is the case today – it ceases to be an effective way of managing risk and becomes highly risky. A more flexible approach is likely to deliver better results – one that considers the full fixed income spectrum, in particular regions and countries less correlated to major markets. One way to accomplish this is to divide holdings into three core components: core stable, returnseeking and defensive positions.

Core stable positions are those with small but steady income or gain potential and a low risk profile, and may include highconviction positions in markets with a low fat-tail risk, as well as shorter-dated IG corporate products. Return-seeking positions include high-conviction investments that have strong potential for capital gains or high income characteristics. They may include locally denominated EMD and select HY names.

Defensive positions, such as inflation-linked products and shorts in vulnerable currencies and sectors, will typically do well in a risk-averse environment.