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 (October 2007 – October 2012), the correlation between high yield and the S&P 500 has been approximately 0.62.* However, during the onset of the financial crisis from 9/15/08 – 10/15/08 this correlation increased to 0.79. More recently, 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.
What does this mean for investors? High yield can be a good asset class for building yield into a portfolio, but it does not have the same diversification properties that are often looked for in a bond investment. This is especially true during falling equity markets when such diversification may be desired most. This is not to say that investors should shun high yield as an asset class. Indeed, any higher yielding asset is likely to exhibit similar behavior. Rather, investors should set realistic expectations for yield targets and obtain that yield from diversified sources (e.g., high yield bonds, EM bonds, dividend stocks, long duration US Treasuries or corporates).
In the end, yield is never free. It is just a question of what risks an investor wants to take and how they construct their portfolio.
*Correlations were calculated using daily observations between the market price of iShares iBoxx High Yield Corporate Bond Fund (NYSEArca: HYG) and the S&P 500.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.