Equities and bonds have been moving in lock-step recently, which is rather unusual since they tend to move in opposite directions because they are negatively correlated. If stocks fall due to geopolitical tensions, bonds tend to rally, giving investors some protection, said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC.
For the few weeks in late July and early August, the correlation turned positive for the first time since the European crisis. One of the challenges of such a situation is that it increases the overall risk of investors’ portfolio because both asset classes move in the same direction in unison, Guy noted.
Asked if he would attribute it to the Fed’s taper talk, Guy answered in affirmative. The Federal Reserve basically increases the value of all assets by entering into quantitative easing or cutting interest rates because investors then can buy any assets due to excess liquidity in the system. The reverse order follows when they get ready to wind down stimulus, he explained.
Asked how investors could hedge their risks in the current situation, Guy said investors should lower the duration of their bond portfolios. For the uninitiated – duration measures the change in price in bonds due to a change in yield.
Price and yield move in opposite directions; i.e. if yield rises, price falls and vice-versa. The term “duration” is generally used interchangeably with maturity. Price analysis of short-term bonds show they provide stability in a portfolio compared to a combination of long-term bonds and stocks.
Low duration portfolios are not designed to earn big returns, but they surely protect investors’ capital. The benefit of lowering the duration of a bond portfolio now is that they will bring-back some of the benefits of diversification and reduce volatility. The gains may be small, but they would still be positive, he argued.
Asked if investors should consider investing in short-duration bonds, Guy said investors should consider staying invested in short-duration bonds for the next couple of years because inflation is expected to stay low for that period. Hence, after adjusting for inflation (and excluding Treasury notes), investors could expect positive returns in short-term corporate bonds, he noted.
Asked to explain the risks that investors face in the short-term, Guy said the number one concern is the September 22 German Federal elections. Analysts are viewing the election as a referendum as to whether the German population wants to continue supporting other areas of the eurozone, and it could have other long-term structural implications on the euro economy.
The other major concern is the upcoming debate in mid-October over raising the US debt ceiling. Markets have probably become a little complacent, because the issues were resolved successfully when they came up for discussion in the past. Investors, however, needs to exercise caution this time around, he warned.
You can watch the video here.