Investors searching for assets that aren’t correlated with U.S. equity markets should look at high-quality bonds, suggests research from Merrill Lynch & Co. Inc.

“Since the deflation of the technology bubble, many investors have searched for assets that are ‘uncorrelated’ to the S&P 500. These asset classes, like hedge funds, non-US stocks, and small cap stocks, seemed in 2000 to not only provide significant diversification benefits, but also offered higher returns,” it notes.

Also, it reports that persistent low returns have caused some investors to use additional leverage to boost returns in these asset classes. “The theory was the risks associated with the leverage were immaterial, when compared to the significant risk-reduction benefits of investing in ‘uncorrelated’ assets,” it adds.

However, it now says that while that theory worked eight years ago, “our analysis continues to show that 2000’s non-correlated asset classes are now often highly correlated to the S&P 500, and their diversification benefits now seem to be greatly reduced, if not completely eliminated.”

In addition, the on-going deflation of the global credit bubble is making leverage more expensive, Merrill says.

“Investors searching for negatively correlated assets should focus today on high quality bonds,” it advises. “Investors should view high quality bonds similarly to their view of hedge funds and non-US stocks 8-10 years ago.”