Consider Correlation When Interest Rates Rise
In our last blog, “All Fixed Income Sectors Are Not Created Equal,” we examined how interest rate changes impact various fixed income sectors differently, with shorter-term bonds offering the best long-term potential in a rising-rate environment. As a follow-up to that discussion, today we’ll consider the correlation of fixed income sectors to U.S. Treasuries and how certain sectors offer greater diversification potential within a bond portfolio.
Correlation, simply put, measures the similarity of returns of one investment to another. An investment with a correlation of +1 means that it has perfect positive correlation to another investment, or that as one investment moves up or down, the other investment moves in tandem. An investment with a -1 correlation means that it is perfectly negatively correlated, or that its returns move in the opposite direction.
The chart below shows the correlation of various fixed income sectors, as represented by their corresponding indexes, to the benchmark 10-year U.S. Treasury. With Treasury rates low, sectors with low or negative correlation—such as floating-rate bank loans, corporate high yield bonds, and commercial mortgage-backed securities—offer the opportunity for investors to diversify their traditional fixed income portfolios, help offset an increase in interest rates, and generate more income in a low yield environment.
10-YEAR CORRELATION, 4/1/04 – 3/31/14
Source: Morningstar Direct.