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Bond Convergence

So far this year, the returns of corporates and Treasuries are again becoming more correlated

Eric Jacobson, 08/26/2013

This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000. 

Despite—in fact, because of—the fat overall returns for corporate bonds since the financial crisis began to soften in early 2009, high-grade corporate bonds have become a lot more of what they once were: modest providers of excess yield, but with considerable interest-rate exposure. We saw this during the second quarter of 2013. With the exception of the shortest-dated debt, Treasury bond yields rose across the maturity spectrum by similar amounts; the 10-year note gapped out roughly 80 basis points from May through June. With a few exceptions, longer-maturity Treasuries naturally lost more than their shorter cousins. The losses incurred were some of the sharpest suffered over a single month in a long time. The Barclays U.S. Treasury Index tumbled 1.9% for the quarter through June 28, 2013.

If you’ve been listening to the pundits, meanwhile, you also probably know that PIMCO Total Return PTTRX suffered losses; it fell 3.6% for the three months ending June. Interestingly, the fund’s outsized pain in May didn’t trace to its increased stake of conventional Treasuries from the month before, but mostly to a long-standing, long-maturity allocation to Treasury Inflation-Protected Securities; the fund’s 8% emerging-markets allocation hasn’t been helpful, either. At the same time, the Barclays Aggregate U.S. Bond Index fell 2.3%, while the average intermediate- term bond fund suffered a 2.6% loss.

More Than Meets the Eye
In fact, there’s more to the second-quarter story than just Treasuries. Some of the most credit-sensitive— and, therefore, more yield-rich—sectors were cushioned from that market’s influence, and Barclays’ high-yield index dropped a comparatively mild 1.4%. Lost in the headlines, however, was that in addition to TIPS, higher-quality corporate bonds also endured particularly hefty losses. The firm’s U.S. corporate-bond benchmark actually fell even more than its Treasury counterpart, with a 3.3% loss.

There’s some interesting nuance to those numbers. The yield spread between the corporate and Treasury indexes widened only modestly during the quarter, suggesting that investors weren’t making a loud statement that corporate bonds were any less desirable from a credit standpoint. On the other hand, it does help highlight the fact that the high-quality corporate-bond market is plenty sensitive to interest-rate moves. In part that’s because the corporate-bond market skews to longer-maturity issuance than the Treasury market currently does. But it also highlights that corporate yields have come in so close to Treasuries’ in recent years that their fortunes have for now become intertwined. In fact, that “yield spread” is still close to its tightest level since before the financial crisis.

Back in the Day
The corporate and Treasury indexes have years of history during which their returns—and directions— were closely linked. They diverged a little in the early part of the 2000s but really went their separate ways in 2007, when financial-crisis worries began sending the two sectors in opposite directions. They’ve converged again for stretches since the crisis but have otherwise shown a lot of independence. In 2012, their return gap was a healthy 783 basis points.

But over the past several months, the returns of the two indexes have again converged. The above exhibit shows that the indexes’ returns were highly correlated for the first six months of the year.

These days, it’s pretty clear that taking on high-quality corporate bond exposure also means taking on interest-rate exposure. It is, therefore, worth taking a good look at your portfolio and eyeballing just how much of your credit exposure comes in the form of high-quality corporate bonds. A large number of high-quality corporates isn’t necessarily bad, but at least for now, it doesn’t appear to offer much diversification from Treasuries, either.

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Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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