The Importance Of Quality In Diversification

by Gene D. Balas

When investors diversify their equity portfolio by adding bonds, not all bonds are created equal in this regard. Certainly, corporate bonds, including both high yield and investment grade, do pay a yield premium over Treasuries. If you’re after income, that might be a worthwhile consideration, but if you’re focused on providing a means of diversification to stocks, you might want to emphasize quality. And that means Treasuries, as even AA-rated corporate bonds can impede levels of diversification vis-à-vis bonds that carry no credit risk, as we will see.

Stocks and bonds can move in tandem at some times

Before we get into a discussion on what types of fixed income, if any, one might use in a diversified portfolio, we would be remiss not to mention one critical area where bonds and stocks might move in tandem. For example, investors already expect the Fed to move two or three times this year, so that much may already be priced into the markets. However, if the Fed indicates it is more worried than investors now think about things ranging from inflation to asset bubbles, and/or that it wants to move faster than the markets expect, that can upset both the bond and stock markets simultaneously.

The market’s volatility gauge tends to correlate with investment grade bond credit spreads

With that caveat out of the way, let’s look at how components of even investment grade corporate bond prices can move in tandem with stocks. First, let’s look at how the popular “fear gauge” investors often follow, the VIX – the implied volatility of the stock market obtained from options prices – correlates with yields of bonds rated AA by Standard & Poor’s. An “AA” rating is solidly investment grade. We’ll focus on the difference of AA-rated corporate bond yields and that of Treasuries of the same maturity, known as the credit spread. When investors are fearful, both the VIX and credit spreads rise, as seen in the nearby graph, and when investors aren’t so worried, these measures fall.

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Even investment grade corporate bonds can underperform Treasuries in periods of risk aversion

Let’s think about this a bit differently. As you probably know, when yields rise, bond prices fall. When credit spreads rise, corporate bonds tend to underperform Treasuries, as the yield for corporate bonds is either rising more or falling less than yields on bonds that have no credit risk.

Now, what happens to credit spreads when equity markets tumble? We can look at the neatly inverse relationship between credit spreads on AA-rated corporate bonds – again, these are solidly investment grade – and the S&P 500 in the nearby graph. What we see in the nearby graph that credit spreads often rise when the stock market falls. That makes intuitive sense, as what constitutes a risk for the stock of a company also may be a risk for bonds issued by the same company, multiplied, of course, across the entire universe of tradeable securities.

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There may be some signs of risk in the equity markets

Why does this matter now? Consider a different item, that of whether risks are present in the equity markets. It is very difficult to predict market returns, especially over shorter time periods. But what we can do is at least take a look at what some signals of risk tell us. Many investors tend to be contrarian for a reason: when others are bullish, all the good news might already be priced into the market. So, when sentiment is high, that, to some investors at least, is a signal that markets may be more fully valued than not.

This is especially the case when the price/earnings ratio for the S&P 500 is currently 24.7, using earnings over the past twelve months, according to Dow Jones data. A year ago, the P/E ratio was 20.9. The long term history for this measure is 16.7 since the 1870s. Put a different way, earnings would have to increase by roughly 50% to bring stocks back to their long term P/E average.

Now consider the nearby graph that looks at the sentiment measures I mentioned earlier – how bullish or bearish investors are – with certain technical indicators[i], or “internals”, contained within patterns of stock price movements, courtesy of BMI and The Wall Street Journal.

So, if there are risks to the market – and we’re not making a forecast of a specific outcome – then investors might want to consider how well risks are diversified when using bonds. So, even though Treasury bonds may yield a bit less than corporate bonds, there may be some advantages to using them if your purpose for owning them is diversification. And of course, recall the caveat above that sometimes, risks can present themselves for both stocks and bonds simultaneously, no matter the credit quality. A prime example would be a larger than expected increase in inflation that might lead to a faster pace of rate hikes by the Fed than what the market currently expects.

The bottom line is that U.S. Treasury bonds are assumed to be the ultimate risk-free security (other than, of course, pertaining to interest rate risk). If one is attempting to diversify risky assets through a bond position, well then, perhaps quality should be a top consideration.