Some tourists are notorious for choosing holiday destinations based on upbeat marketing campaigns and attractive weather reports, failing to understand any difference in the cultural or social customs of their chosen location. This foolish approach can lead to issues on arrival, and often times ends with the tourist upsetting the locals and getting themselves into trouble. This is not dissimilar from what has happened in fixed income markets in recent years. The hunt for yield has seen a large amount of “yield tourism,” whereby investors put money to work in the highest yielding parts of the fixed income universe without understanding the potential risks. One of simplest concepts in finance is that higher yields come with greater risks; unfortunately, in the fixed income market, this has recently been overlooked.
The chart below depicts the correlation of fixed income sectors to the S&P 500 compared to their yield. One key dynamic to note is that those sectors with a higher correlation to equities tend to have a higher yield. In the early days of an economic expansion this stronger correlation is not too much of an issue, as the recovery is still young and a bear market is unlikely. However, as we get into the later parts of the cycle and the chance of a bear market in equities increases, investors need to be more discerning when it comes to fixed income positioning. While rebalancing away from sectors such as high yield and emerging market debt in favor of core fixed income options like U.S. Treasuries may reduce your yield, it also could provide protection in the event of an equity market drawdown.
Correlation of fixed income sectors vs. S&P 500 and yields
Source: Bloomberg, FactSet, ICE, J.P. Morgan Asset Management. Data as of 7 July 2018. International fixed income sector correlations are in hedged US dollar returns as US investors getting into international markets will typically hedge. EMD local index is the only exception – investors will typically take the FX risk. Yields for all indices are in hedged returns using three-month LIBOR rates between the US and international LIBOR. The Global ex-US aggregate is a market-weighted LIBOR calculation. Data as of 27 September 2018.