In this week’s OppChart, we explore the correlations between the various sectors of the Barclays U.S. Aggregate Bond Index and the broad index.  For much of the 30 years leading up to the financial crisis of 2008, the quarterly correlations between the sectors and the broad index hovered close to 1.  With all of the sectors generally moving in unison, the bulk of returns generated by high quality fixed income investors over that time were the result of accurately predicting moves in interest rates rather than through asset allocation.

Then the crisis came along, and the correlations amongst the returns of the various fixed income sectors and the broad index wildly diverged.  This makes intuitive sense.  In the height of the crisis, perceived safe-haven assets such as U.S. Treasuries rallied, while commercial mortgage-backed securities and asset-backed securities fell under significant pressure.  By 2009, correlations between the various sectors of the index and the broad index had fallen to 0.5.  Asset allocation reigned supreme. 

The correlations appear to once again be trending higher.  For investors overexposed to funds indexed to the Barclays U.S. Aggregate Bond Index this means that there might be little place to hide as interest rates rise.  Consider the price returns of select sectors of the index from when rates bottomed on July 24, 2012 through this February: Treasuries -3.97%; Agencies -1.88%; Mortgage-Backed Securities -1.41%; Investment-Grade Corporates -1.12%.  Compounding the problem, in today’s low rate environment, many high quality bonds no longer offer high enough income streams to provide positive total returns in the event of a prolonged rising rate environment.

Investors need to rethink how to allocate the 40% of their portfolio typically assigned to fixed income.  A more diversified 40% would seek higher income, and greater potential protection, against rising rates and other risks than that offered by the Barclays U.S. Aggregate Bond Index.  It would include allocations to more credit-sensitive instruments like high yield bonds and senior loans, exposure to international bonds, and an allotment to diversified alternative assets, including real estate investment trusts and master limited partnerships, which may provide high current income and low correlations to traditional fixed income securities. 

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