Conditional Fixed Income Correlations: Skews and Straddles

Abstract

We apply extreme value and copula theory to estimate conditional correlations of various pairs of US fixed-income assets. This framework is applied to both co-movements of fixed-income assets, and cross-movements of fixed-income assets where one, typically flight-to-quality, asset strongly outperforms and the other, typically a risky spread product, strongly underperforms. Our results show that for co-movements between risky spread products the correlation structure resembles a straddle where conditional correlations monotonically increase both with increased market stress and with increased market rallies. This finding stands in contrast to the correlation patterns found in international equity markets and hedge fund strategies for which the correlation structure has the shape of a skew with increased correlations under extreme market stress and zero correlations during risk-on episodes. We also find this skew shape in the correlations between US fixed-income assets when we estimate conditional correlations for cross-movements with a flight-to-quality asset performing strongly during periods of stress and risky spread products considerably widen. Under these conditions, conditional correlations are very negative, but monotonically fade with market recoveries to eventually become zero during risk-on episodes. TOPICS: Fixed-income portfolio management, tail risks, statistical methods Key Findings • This study presents the first analysis of extreme value and copula theory applied to correlations estimations of various pairs of fixed-income assets conditioned on market sentiment. This method is immune to small sample biases present in subsampling methods. • Our results show for co-movements between risky spread products that the correlation structure resembles a straddle, where conditional correlations monotonically increase with increasing market stress and increasing market rallies. This finding is novel and contrasts patterns observed in equity markets. • We find a skew shape in conditional correlations in fixed-income markets between flight-to-quality assets and risky spread products in cross-movements. Conditional correlations are very negative during periods of stress but monotonically fade with market recoveries.