Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 403

Do bonds still offer a buffer to equity volatility?

The relationship between bonds and equities is a feature of all balanced portfolios, especially how the price of one moves in relation to the other. Correlation is a measure of the strength of the co-movement, with a positive correlation indicating prices usually move in the same direction.

As this relationship drives the performance of superannuation for many Australians, it’s useful to know how the correlation between bonds and equities has varied over longer time periods. This article also looks at some of the key drivers of the correlation structure, and how different levels of correlation impact a portfolio’s performance.

Correlation between bonds and equities over longer time periods

Questioning the persistence of the negative correlation between equity and investment grade fixed income price returns (that is, when equities rise, bond prices fall and rates rise, or when equities fall, bond prices rise and rates fall) has become timely because of the intersection of a few topics.

In particular, co-movement of the equity and sovereign bond markets during the March 2020 market sell-off reignited the concern about the hedging potential offered by fixed income assets. This led to a reinvestigation of the sovereign bond-equity correlation relationship, a relationship that has been negative over the past two decades. Many argue that much of this negative correlation can be attributed to the lowering and persistently low levels of inflation over this same period.

While stock and government bond prices have been moving in opposite directions since the beginning of the new millennium, the correlation prior to around 1997 in the US, as seen below, was broadly positive for more than a century. Using data going back to the mid-19th century, the correlation between equities and bonds has been mostly positive, making the recent and consistent stretch of negative correlation the anomaly, rather than the rule. (EMA=Exponential Moving Average).

Long-term evidence of positive correlation between bonds and equities

How do different levels of correlation impact returns?

Investors use the Sharpe ratio as a measure of risk-adjusted returns, or how much excess return you receive for taking more risk. You would expect a higher return from an equity portfolio than a bond portfolio over time because equities are more volatile (and, by this measure, riskier).

The table below shows the Sharpe ratios of a 60/40 portfolio in three different time periods: 1980-today, 1980-1998 and 1998-today.

The latter two periods are characterised by the flip in correlation that occurred in 1997. In the first column of the table, we assume an arbitrary -0.4 correlation between equities and bonds and recalculate the Sharpe ratios. We repeat for the second column with an arbitrary +0.4 correlation.

What is striking is the increase in pre-1998 Sharpe ratio from 0.78 to 1.14 by flipping the correlation, and from 0.40 to 0.51 following the same flip in sign for the period post-1998. So the risk-adjusted returns of a 60/40 portfolio are very sensitive to the level of correlation between equities and bonds!

How have other ‘safe-haven’ assets performed in difficult markets?

Asset managers have become accustomed to being able to rush into the safest and most liquid of assets, typically US treasuries, as a hedge when equity markets sell-off.

The ‘protective’ property of so-called ‘safe-haven’ assets such as US treasuries (and other low risk sovereign debt, gold, and especially the currencies of the US, Japan, and Switzerland) has been called upon to hedge equity exposure in periods of high (and often continued) market stress and significant drawdowns.

However, this market feature, looking back over the past 60 years, has only recently been available to all investors. In the table below we show all equity drawdowns (market falls) greater than 10% since the 1960s. We tabulate the total return of the S&P 500 from peak to trough, along with the comparative total return of US treasuries along with other major safe-haven assets. There is a distinctive pattern, corresponding with the correlation structure of equities and bonds as discussed above.

Before the end of the 90s, bonds typically moved in lockstep with equities, offering no protection to investors during these, the most severe drawdowns. Even in the couple of cases it did, the returns were marginal. However, after the end of the 90s, the pattern changed markedly, when, in most cases, bonds acted as an effective hedge against the equity sell-off.

Our conclusions

Given these observations, both the return and hedging potential of bonds are reduced when interest rates are low and correlations are positive.

If bonds become a less effective hedge for portfolios, investors will be left with few choices other than an expensive portfolio of options. We think they would be better advised to look for alternatives to bonds for diversification in the current environment.

 

Craig Stanford is a Director of Capital Fund Management. This article is general information and does not consider the circumstances of any investor. Any description or information involving investment process or allocations is provided for illustration purposes only. There can be no assurance that these statements are or will prove to be accurate or complete in any way. All figures are unaudited. This article does not constitute an offer or solicitation to subscribe for any security or interest.

 

RELATED ARTICLES

An insider's view of the last financial crisis

Red pill or blue pill? Navigating the matrix of fixed income

5 lessons from the GFC as panic whips hybrids

banner

Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Three ways index investing masks extra risk

There are thousands of different indexes, and they are not all diversified and broadly-based. Watch for concentration risk in sectors and companies, and know the underlying assets in case liquidity is needed.

Investment strategies

Will 2022 be the year for quality companies?

It is easy to feel like an investing genius over the last 10 years, with most asset classes making wonderful gains. But if there's a setback, companies like Reece, ARB, Cochlear, REA Group and CSL will recover best.

Shares

2022 outlook: buy a raincoat but don't put it on yet

In the 11th year of a bull market, near the end of the cycle, some type of correction is likely. Underneath is solid, healthy and underpinned by strong earnings growth, but there's less room for mistakes.

Gold

Time to give up on gold?

In 2021, the gold price failed to sustain its strong rise since 2018, although it recovered after early losses. But where does gold sit in a world of inflation, rising rates and a competitor like Bitcoin?

Investment strategies

Global leaders reveal surprises of 2021, challenges for 2022

In a sentence or two, global experts across many fields are asked to summarise the biggest surprise of 2021, and enduring challenges into 2022. It's a short and sweet view of the changes we are all facing.

Shares

What were the big stockmarket listings in record 2021?

In 2021, sharemarket gains supported record levels of capital raisings and IPOs in Australia. The range of deals listed here shows the maturity of the local market in providing equity capital.

Economy

Let 'er rip: how high can debt-to-GDP ratios soar?

Governments and investors have been complacent about the build up of debt, but at some level, a ceiling exists. Are we near yet? Trouble is brewing, especially in the eurozone and emerging countries.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.