It’s no secret that 2022 was a difficult 12 months for nearly every asset class across the board. While U.S. stocks fell greater than 20%, average fixed income securities didn’t fare a lot better: most fell at the very least 10%.
Of course, bonds and other fixed-income assets are intended to supply diversification advantages and supply a buffer of sorts in case the equity component of a portfolio falls on hard times. Apparently they have not been performing these functions particularly well recently. With this in mind, we wanted to know when fixed income investments actually did what portfolio managers and investors expect them to do.
We checked out the returns of the S&P 500 and the common total bond fund since 1970 and analyzed how the correlations between them have modified over time. We tested the correlations in several rate of interest environments in addition to in changing rate of interest environments.
So what have we found?
Using the federal funds rate as a proxy, the best correlation between bond and stock returns occurred in a rising rate of interest environment. This reflects the present situation. As the Federal Reserve tries to curb inflation, bond yields will not be offsetting losses within the stock market, but moderately are falling roughly in step with stocks.
In fact, we discover that the correlation between stocks and bonds is lowest in a flat rate of interest environment. Whether it’s because such an environment coincides with essentially the most stable economic times is an open query. Regardless of the cause, nonetheless, when rates of interest are static, bonds and glued income appear to supply the best diversification advantages and the bottom correlation with stocks.
Average stock-bond correlation by rate of interest environment
| Rising rates of interest | 0.5257 |
| Flat rate prices | 0.3452 |
| Falling rates of interest | 0.4523 |
Next, we examined the correlations between stocks and bonds in low-, medium-, and high-yield environments, i.e. when the federal funds rate is below 3%, between 3% and seven%, and above 7%, respectively. Here we found that the correlation between stocks and bonds is highest when the federal funds rate is above 7%. Conversely, in low rate of interest environments, bonds offer the best diversification advantages or the bottom correlation with stocks.
Stock-bond correlations in several federal funds rate environments
| Over 7% | 0.5698 |
| Between 3% and seven% | 0.4236 |
| Less than 3% | 0.2954 |
Finally, we examined how the advantages of diversification change during recessions. To do that, we isolated the correlation between stocks and bonds initially of every of the seven recessions since 1970 after which compared that to the correlation between stocks and bonds at the tip of that exact recession.
Correlations increased in five of the seven recessions, with the most important spikes occurring throughout the 1981 recession and the Great Recession.
What lesson can we learn from this? That the diversification advantages of fixed income are least effective precisely after they are needed most – during a recession.
Stock-bond correlations during recessions
| End of the recession | Start of recession | Change | |
| November 1973 to March 1975 | 0.7930 | 0.7095 | 0.0835 |
| January 1980 to July 1980 | 0.4102 | 0.7569 | -0.3468 |
| July 1981 to November 1982 | 0.6955 | 0.0282 | 0.6673 |
| July 199 to March 1991 | 0.7807 | 0.5156 | 0.2651 |
| March 2001 to November 2001 | -0.1957 | 0.3754 | -0.5710 |
| December 2007 to June 2009 | 0.8284 | -0.2149 | 1.0433 |
| February 2020 to April 2020 | 0.7364 | 0.3369 | 0.3995 |
This presents a significant dilemma for investors and portfolio managers alike. In times of recession or rising rates of interest, we cannot depend on the hedging effect of fixed income securities.
This signifies that in bear markets we want to look to other asset classes to guard ourselves – perhaps commodities or derivatives. Of course, they could not have the ability to shut the gap either.
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