In a perfect world, a diversified portfolio would have asset classes that are uncorrelated, allowing an investor to maximize return while minimizing risk. As every high yield portfolio manager has probably told you, high yield bonds have had low correlations with other asset classes, and they can offer attractive risk-adjusted returns. This low level of correlation has allowed investors to benefit from allocating to high yield bonds. According to Barclays, monthly high yield bond-return correlations have been negative versus U.S. Treasurys over the past twenty years. Obviously, that correlation statistic includes a time period of declining Treasury rates.
So what have correlations done during the most recent increase in rates?
Despite what feels like a 1.00 (perfectly positive) correlation to rates, high yield bond daily-return correlations to the Barclays U.S. Treasury 5-7 Year Index since May 1 are elevated, but still remain relatively low, only 0.20 (unless otherwise noted, all performance information is as of August 27, 2013). Read more
For those involved in trading the fixed income markets, August is usually one of the more mundane months. Issuance of new corporate debt slows down significantly since many global investment professionals are on vacation, forced two-week leaves, or holidays, which results in liquidity that is much more challenging. But unlike past years, we’re entering into a September time frame that is poised to be anything but boring, thus causing a likely increase in volatility. So just like the coming attractions at your local movie theater, this is what we have to look forward to in the month of September:
Specific events and their release date:
- “The Last Picture Show” (September 6) – On this Friday, the final major piece of the employment puzzle, the August non-farm payrolls, will be released to the market. This will either confirm the prevailing wisdom regarding the underlying strength of the U.S. economy and the likelihood of tapering of the Fed’s quantitative easing program, or it will provide a difficult conflicting perspective only days before the FOMC meeting. Read more
Mark Carney has really put his stamp of authority on the Bank of England (BoE). After just one month as the BoE’s new governor, he’s already shaking things up. At the latest meeting of the Monetary Policy Committee (MPC), he introduced forward guidance that would have been almost unimaginable under the previous Governor, Mervyn King.
Here’s what Carney’s forward guidance looks like. The MPC intends not to raise their benchmark bank rate from its current level of 0.5% until the unemployment rate falls to a threshold level of 7%. This is subject to three caveats:
- inflation is no higher than 0.5% above the 2% inflation target at the 18-24 month horizon
- medium-term inflation expectations are contained
- and the Financial Policy Committee (FPC) believes that an accommodative monetary policy stance doesn’t pose a risk to financial stability. Read more
We can give three simple reasons to support the use of volatility products to hedge tail risk in fixed income portfolios. First, equity volatility and bond prices have a strong conceptual link. If you think of a corporate bond as functionally equivalent to a risk-free asset (like a Treasury bond) plus a short put option on the issuer’s assets, then the additional yield you receive above the Treasury rate (a.k.a., credit spread) can be thought of as compensation for the sale of that put option. When equity market volatility jumps drastically (as it does during a tail-risk event), the implicit liability from the short put position increases in probability. In a nutshell, the value of bonds will fall as market volatility (yes, even equity market volatility) rises. Read more
The Reserve Bank of Australia must be feeling pressure to provide financial markets with explicit forward guidance on the long-term direction of its interest rate strategy. These days, with central banks all over the world providing markets with forward guidance on rates in an effort to shape market expectations, the RBA is one of the few remaining major central banks to maintain a sense of anticipation at each meeting – rates could just as easily go up as they could go down. Even the European Central Bank has finally backed away from its sacred no “pre-commitment” policy. Check out my previous post on forward guidance here.
Increasingly these days, what was once considered to be “abnormal,” markets are beginning to construe as “normal.” A central bank that doesn’t provide forward guidance is increasingly seen as hawkish (“do they have something to hide?”) and markets tend to react by driving up its bond yields and their respective currency – effectively tightening financial conditions.
Chapter 9 – words that are going to be on a lot of lips for some time to come. Last week, Detroit filed for bankruptcy protection under Chapter 9 of the United States Bankruptcy Code, and the Motor City became the largest municipal bankruptcy in history – definitely a dubious distinction. The financial press has focused most attention on the immediate impact to investors in Detroit’s debt, but in our opinion, there will be effects felt by municipal bond investors more broadly, as well as by Detroit’s citizens and workers.
A good deal of ink was spilled last week about how some municipal bond market participants were “concerned” about how some of the city’s general-obligation bonds (those are municipal bonds backed by the full faith and credit of a municipality) were classified as “unsecured” by the Detroit’s emergency manager. Read more