Wealth Manager - the site for professional investment managers

Register for full access to Citywire’s Fund Manager database, news and analysis. Registration is free and only takes a minute.

Nick Sketch: Negative gilt/equity correlation is trap for the unwary

Nick Sketch: Negative gilt/equity correlation is trap for the unwary

To most of us, gilts look like terrible investments for all but the very short term – but many said that a couple of years ago and were wrong.

Gilts arguably still offer less absolute risk if held to redemption than cash on deposit, and some may well beat cash returns – unless you can move the cash around every year to collect a bonus deal.  The absolute prices move of course, but shorter-dated gilts are not exactly volatile, even when everything else is.

These, and the particular attractions of index-linked gilts (inflation protection for all, plus tax treatment for high rate payers), all represent good potential reasons for even long-term investors to consider gilts. However, there is another reason – powerful but a good deal less certain.

Correlation is a key issue when building portfolios. As many discovered, holding assets that are usually uncorrelated is of no use if they become very correlated during a crash.

However, gilts have been a constant in the past few years – when equities fell, gilts rose. This encouraged a view that adding some gilts to an equity portfolio is like buying some put options or insuring your house – you do not expect or want it to make you money, but the peace of mind can make it good value anyway.

For the moment, there seems no reason to expect this negative correlation between gilts and equities to disappear or reverse.

 

The chart shows the correlation between US bonds and equities since 1875. Negative correlation seems typically to appear in two situations – when equities are fiendishly expensive or when deflation is the key risk. (No prizes for guessing which applied in 2000 and which applied in the past few years.)

Given the nature of gilts, this negative relationship appearing at such times is not surprising, but this pattern does point to a possible risk. If money-printing eventually leads to rising inflation, we could find that gilts are not merely bad stores of real value, but also that they do not dampen the returns from equity investments either, and represent neither good value nor good insurance. For example, rising inflation in the 1970s saw this correlation become very positive.

For now, deflation is still a risk and holding gilts as insurance may therefore not be a bad idea, but it would be dangerous to assume that the conventional wisdom of negative correlation will remain true forever.

Leave a comment!

Please sign in or register to comment. It is free to register and only takes a minute or two.
Citywire TV
Play Inside ETFs: Why the US bull-run still has legs

Inside ETFs: Why the US bull-run still has legs

Global equities suffered a sharp sell-off in the third quarter but exchange traded fund investors are continuing to back the US to outperform in 2015

Play Paul Niven: I won't rip up the Foreign & Colonial Trust history book

Paul Niven: I won't rip up the Foreign & Colonial Trust history book

The newly appointed manager of the Foreign & Colonial trust talks about his plans for UK's oldest investment company.

Play Dangerous daisy chains, Black Friday blues and Uber valuations

Dangerous daisy chains, Black Friday blues and Uber valuations

This week’s Investment Pulse looks at the domino effect in European banks, America’s disappointing Black Friday and how much Uber is really worth.

Your Business: Cover Star Club

Manchester wealth firm hires Coutts director for London launch

Manchester wealth firm hires Coutts director for London launch

Former Coutts director Tony Robinson has joined Chartered Wealth Management to head the company’s newly opened London office.

Wealth Manager on Twitter