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.

1_Correlated_Returns_S&P_500

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.

 

Think of it this way: When do investors need diversification? Do they need it during bull markets? Absolutely not. In fact, when stocks are rallying, they would do better to concentrate their holdings in high-octane, high-beta assets.

The time investors really need diversification is when the markets turn, and they’re looking for uncorrelated assets to buffer portfolio volatility. And guess what? High-yield bonds will probably not do that job very well. The same goes for floating-rate bank loans, by the way.

OK, now that we have all the ominous warnings out of the way, here’s the ironic punch line: Investors can probably avoid all the pitfalls we’ve discussed if they just maintain discipline and refrain from making knee-jerk decisions when they suffer short-term losses.

Sure, the stock market can correct sharply and high-yield bonds can follow along, causing deep, painful portfolio losses for a number of months. If they choose to sell their high-yield bonds after the correction, they lock in their losses. For instance, selling high-yield bonds at the end of 2008 would have resulted in a loss of -26.2 percent over the prior 12-month holding period.

However, if they had chosen to hang on to those investments, they would have realized significant profits in their high-yield bonds by year three.

In most cases, over the long term, nearly all total returns generated by diversified bond portfolios come from their income. Bonds are issued at par and mature at par. So long as defaults are not significant, cumulative returns are a function of the amount of income distributed and the investor's holding time.

Annualized_Returns_S&P_500

How does investor discipline factor into the equation?

If investors have the discipline to avoid the temptation of bonds that could produce short-term losses greater than they can handle, or be willing to continue holding bonds that have delivered painful short-term losses, they can generate solid returns regardless of fluctuations in the broader markets.


Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330 or sageadvisory.com.

 

 

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