Let’s look at two examples of this kind of dislocated market: the 2008 financial crisis and the US Treasury downgrade in August 2011. Over the past five years (January 2010 – January 2015), the correlation between high yield and the S&P 500 has been approximately 0.73. However, during the onset of the financial crisis from 9/15/08 – 10/15/08 this correlation increased to 0.79. In the aftermath of the US Treasury downgrade during August 2011 the correlation jumped to a whopping 0.97 – meaning that high yield and equities were moving almost in lockstep with one another.
Market Realist – High yield bonds are not good diversifiers
The asset correlation matrix above shows the correlation coefficients between Treasuries, high yield bonds, investment grade corporate bonds, and the S&P 500 (SPY)(IVV). The iShares Barclays 7–10 Year Treasury Bond Fund (IEF) tracks Treasuries, and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) tracks high yield bonds. Lastly, the iShares IBoxx $ Investment Grade Corporate Bond Fund (LQD) serves as a proxy for investment grade corporate bonds. The matrix uses monthly returns for ten years.
From a portfolio diversification point of view, the correlation between two asset classes should be close to zero. A correlation coefficient of one means the two assets move together proportionately, while a correlation of minus one means the two asset classes move in opposite directions.
High yield bonds correlate highly with equities, as shown by the correlation of 0.75 for the last ten years. High yield bonds have a correlation of 0.68 with investment grade corporate bonds, showing a moderate relationship. Hence, high yield bonds are not good diversifiers.
Treasuries, on the other hand, seem to add great diversification benefits to a portfolio that only contains equities. The correlation between the two is -0.27, and the correlation between Treasuries and all other asset classes is also negative.