7497 beware rising correlations year 2010 month 07 itemid 127

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Beware Rising Correlations

Written by Chadd Bennett

  
July 12, 2010 18:17 (CET)

Correlation among asset classes, especially in relation to their risk characteristics, has been getting extremely high recently. In fact, the head of quantitative strategies at Barclays says correlations, at least among stocks, are higher than they were in 1987 and 2008. As a result, this is forcing many to one side of the boat and then to the other as they bounce from risky assets to less risky ones, adding to overall volatility.

The same thing is going on in the fixed income market, in part because the implicit guarantee of credit from the U.S. government is allowing investors the luxury of being able to treat different bonds similarly.

High-quality bonds in different sectors are trading more closely together than ever before. Just look at the chart below of four such bond ETFs: the iShares Barclays MBS Bond ETF (NYSEArca: MBB), the iShares iBoxx Investment Grade Corporate Bond Fund (NYSEArca: LQD), the iShares National Municipal Bond Fund (NYSEArca: MUB) and the iShares Barclays 7-10 Year Treasury Fund (NYSEArca: IEF). It’s clear the grouping has got tighter over the last few months.

There are several reasons for this tightening relationship, one of which, as I mentioned above, is the implicit backing by the government of anything considered too big to fail.

Many portfolio managers and institutions have been buying MBS and agency debt, for example, instead of Treasuries, betting that the government’s backing is a bit more than implicit. This moral hazard was reinforced by the “solution” to the Greek debacle and implies that if states like California or Illinois get into trouble, consequences for creditors will be limited as Uncle Sam will ride to the rescue.

Another reason is that investors remain quite uncertain about the macroeconomic outlook, and have been reluctant to buy individual credits and incur the liquidity risk of holding individual bonds. This, in turn, increases demand for liquid products like bond ETFs and other bond index products that allow portfolio managers to keep their fingers on the trigger should volatility spike again, as it almost surely will. And by now you probably understand how that is increasing correlations.

Another variable pushing correlations to potentially dangerous levels is the low-yield environment we’re in. Since the Fed cut official overnight borrowing rates between banks to almost zero, investors have been looking for yield anywhere they can get it without sacrificing too much in quality – often in the same places. Once again, you know what that’s doing to correlations.

Without question, quality has been king for the first half of the year, especially in the second quarter when capital preservation prevailed as the dominant theme. On a total return basis, MBB, the Barclays MBS ETF, is up 4.88 percent through June 30, while LQD has risen 5.7 percent, and MUB, the muni ETF, has added 3.03 percent. Those returns compare to a 7.3 percent drop for equities, as measured by State Street’s S&P 500 ETF (NYSEArca: SPY), and a gain of 2.4 percent for the iShares iBoxx High Yield Corporate Bond Fund (NYSEArca: HYG).

This week we’ve finally seen a little relief rally, with Treasury yields climbing back above 3 percent and stocks rebounding from oversold levels in the short term. What’s more, MBB, LQD and MUB are all off their peaks as markets show signs of normalizing a bit.

When high-quality credits are as correlated as they seem to be right now, any dramatic change in the market is likely to affect all these debt classes simultaneously. Moreover, in today’s world of leverage and derivatives, the unwinding of extremes can be violent and the catalyst is rarely spotted before it kicks in. What I’m saying is that you need to stay more nimble than ever.

 


Chadd Bennett is a trader and former financial adviser specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney. This article originally appeared on IndexUniverse.eu’s sister site, IndexUniverse.com.

 

 

 


The views expressed by those blogging are for informational purposes only and should not be construed as a recommendation for any security.
 

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