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Nick Sketch: Negative gilt/equity correlation is trap for the unwary
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by Nick Sketch on Dec 04, 2012 at 11:33
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.
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by Dylan Lobo on Apr 17, 2014 at 10:42