Sage's Parish: Not All Bonds Diversify

March 31, 2014

Beware the perils of taking on credit risk to reach for yield, Anthony Parish warns.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Anthony Parish, vice president of Research & Portfolio Strategy at Austin, Texas-based Sage Advisory Services.

We talk to a lot of investors who own bonds to offset the risk of their equity holdings. However, just because an investment claims “fixed income” status doesn't mean it provides much diversification versus equities.

Case in point: High-yield bonds such as the iShares iBoxx $ High Yield Corporate Bond (HYG | B-75) and the SPDR Barclays High Yield Bond ETF (JNK | B-61). At the end of the day, high-yield corporate debt generates returns that are highly correlated to the returns of stocks, and it’s for that reason we regard them as a kind of “equity light” or “decaf equity.”

Although their returns are not usually as volatile as stock returns, they tend to move directionally the same. So, those investors who hold high yield hoping they’ll be protected during a bear market should think again. When stocks correct, high-yield debt tends to follow.

Additionally, over shorter intervals such as rolling three-month and six-month periods, their correlations periodically spike to surprisingly high levels. Remember 2000 and 2008?

By contrast, high-quality bonds such as those found in investment-grade corporate funds like the iShares 1-3 Year Credit Bond ETF (CSJ | A-89) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-66), etc.), or in Treasury portfolios such as the iShares 1-3 Year Treasury Bond ETF (SHY | A-97) or the iShares 10-20 Year Treasury Bond ETF (TLH | B-65), etc.) tend to buffer portfolio volatility to a much greater degree.

Over various time periods, their correlations relative to stocks range from significantly negative to moderately positive.


The explanation is intuitive, and it has to do with the timeless human emotions of fear and greed.

When investors are feeling confident and bullish, they shovel money into investments that generate significant returns. This includes stocks and, if they own fixed income, it often includes high-yield bonds, bank loans and/or emerging market debt.

Conversely, when their risk outlook changes, and they become fearful, pulling money from speculative areas of the market in favor of “flight to quality” investments such as cash and high-quality fixed income.

All that is as it should be, so long as investors understand the role that high-yield bonds play in a portfolio. Sure they can generate high amounts of income, and if the markets stay range-bound for prolonged periods of time, investors can clip high coupons for months and months. But when markets correct, they tend to do so quickly.


Find your next ETF

Reset All