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Using Bonds for Diversification

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Investors are always advised to diversify their portfolios, which at the simplest level means “Don’t put all your eggs in one basket.” The idea is that when one investment in your portfolio is performing poorly, it may be offset by stronger performance by another. The key to diversification is not the number of different investments, but the type of investment.

This is an important consideration for anyone who considering using bonds to diversify a portfolio that is heavily invested in stocks. But when it comes to diversification, not every type of bond is created equal.

One way to measure whether or not an investment can provide diversification versus another is to look at the correlation of the two securities. Correlation involves plenty of complicated math, but what matters for investors is that correlation runs on a scale from -1.0 to 1.0, and the higher the number falls along this scale, the greater the correlation. In other words, a correlation -1.0 indicates that two investments move in completely opposite directions, 1.0 means their performance is exactly the same, and 0.0 indicates no correlation at all. In reality, the most correlation number cluster around the middle of this scale, so anything above 0.5 or below -0.5 indicates a strong relationship.

How to Use This Information to Improve Diversification

This is useful to know, because it can help investors make better diversification decisions. Fidelity Investments calculated the correlation among various asset classes in the period from 1970 through November, 2011. The results are revealing for someone is looking to diversify a stock-heavy portfolio.

The fixed income asset class with the highest correlation to U.S. equities is high-yield bonds, which checked in at very high 0.60.* The reason for this is that high-yield bonds are not as sensitive to interest rates as other segments of the bond market. Instead, it is the health of the underlying issuers that is the most important determinant of high yield bonds’ performance. And more often than not, the same factors that will boost issuers’ finances – such as robust corporate earnings and stronger economic growth – are also positive for the stock market.

Learn more: How does credit risk differ from interest rate risk?

Along the same line, emerging market bonds also have a high correlation with equities: 0.53. The reason for this is the same as it is with high yield. Since the issuers’ creditworthiness is the main factor influencing their prices, changes in global growth and investor sentiment will have a similar effect on emerging market bonds as it does with stocks.

The lesson here is simply that high yield and emerging market bonds are not necessarily the best diversifiers for someone with an equity-heavy portfolio. They do have other attributes that may matter more to certain investors; most notably, both offer much higher long-term return potential than lower-risk areas of the bond market.

On the other hand, three segments of the bond market do indeed provide a measure of diversification versus equities. Treasury Inflation-Protected Securities, or TIPS, have had a correlation of 0.10 with the U.S. stock market since they were first issued in 1997. Short-term bonds also had a low correlation of 0.10 based on the Barclays 1-3 Year Government/Credit Bond Index, which holds both short-term government and corporate bonds. The lowest of all? International (non-U.S.) developed-market bonds, with a correlation of exactly 0.0.

The reason all of these market segments have lower correlations than either high yield or emerging market bonds is that creditworthiness is less of an issue. Instead, interest rate sensitivity is the primary factor in their performance. As a result, they tend to perform better during periods of slowing growth (which in turn causes interest rates to fall and prices to rise), a backdrop that is less favorable for equities.

An Important Caveat

One of the most important takeaways from this discussion is that the correlations of various asset classes are always shifting. While the numbers above provide a general idea of what areas of the bond market may offer the best diversification, there is no guarantee these relationships won’t change in the years ahead. Also, there are – naturally – many considerations in portfolio construction beyond diiversification. Nevertheless, this may provide a guide to investors as to what segments of the bond market work best for diversifying away from equities.

*U.S. equities in this case are measured by the Wilshire 5000 Index, which incorporates both large and small companies.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.

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