The classic case for bonds is that they diversify equity risk, but that fell apart in 2022 when stocks and bonds dropped together. Has that correlation actually flipped back negative, or are we still in a regime where bonds aren’t doing their old job?
The correlation between stocks and bonds has shifted, but not quite as you describe. That doesn’t mean bonds shouldn’t be part of a diversified portfolio.
Let’s step back to clarify what we mean by asset correlation: It’s a measure of the degree to which two assets tend to act similarly. Quantitatively speaking, this is indicated by a coefficient ranging from -1 to 1.
A correlation coefficient of 1 means that the assets are 100 per cent positively correlated: They move in lockstep. A coefficient of -1 means that they always move in opposite directions, and a coefficient of 0 means one asset’s moves won’t help you to predict the other’s.
If you combine assets in a portfolio, and assuming they’re not perfectly correlated, you reduce the portfolio’s overall risk – the volatility of its expected returns – to less than the risk of each component. This is the key to the power of a broad equity index fund. You’re cushioned from the risks of individual stock volatility, but still enjoy long-term gains.
In theory, if you were to find two perfectly negatively correlated assets with equal expected returns, you could eliminate risk and enjoy the same returns. In reality, most portfolios feature a combination of assets with messier correlations and different risk and return characteristics.
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Many investors are also happy to trade some potential returns for protection against significant losses.
That’s where bonds come in. We all know that, over time, equities tend to outperform bonds, and bonds tend to be less risky. But while an all-stock portfolio might outperform a stock and bond portfolio in absolute terms, adding bonds can actually mean improving your returns for the amount of risk you take.
That last part is crucial.
For decades, the diversification benefits of bonds were clear and understandable. The correlation between large U.S. company stocks and U.S. long-term Treasury bonds between 1970 and 2017 was 0.04, according to the CFA Institute.
If you’ve only been investing this century, the benefits have seemed even more obvious. Starting after the turn of the millennium, bonds “tended to deliver positive returns when equity markets suffered losses,” researchers at U.S. hedge fund AQR Capital Management wrote in a 2023 paper in the Journal of Portfolio Management.
In other words, for most of the past 20-plus years, stocks and bonds have been negatively correlated.
As the researchers point out, however, stocks and bonds were actually positively correlated for most of the 20th century. The early part of this century was the exception, not the rule, and recent market events have brought us back toward the historical norm.
A recent AQR blog post revisited the topic, noting that the correlation between stocks and bonds “tends to be positive in environments where inflation uncertainty exceeds growth uncertainty.”
Given high oil prices and continuing concerns around inflation, the positive correlation trend may prove to be sticky.
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ING economist James Smith wrote last month that the traditional hedging role of bonds is being eroded as more frequent supply shocks make it more likely that we’ll see bond and stock prices fall together.
And in a recent note, Scotiabank analyst Hugo Ste-Marie said that when the U.S. 10-year yield rises above 5 per cent, higher bond yields tend to be associated with lower stock prices. (As a reminder, higher bond yields mean lower bond prices.)
The U.S. 10-year yield is currently hovering above 4.9 per cent.
While Mr. Ste-Marie clarifies that 5 per cent is “a loose threshold rather than a mechanical trigger,” the shift in stock-bond correlation may mean investors “need to lean more heavily on alternative diversifiers, including commodities and gold,” as longer-term Treasury bonds may provide less protection in a stock market sell-off.
If that sounds scary, remember this: A positive correlation between bond and stock prices doesn’t eliminate the benefits of diversification.
Even if your bonds aren’t moving in the opposite direction of your stocks, they are still reducing the overall risk of your portfolio, as they did throughout the positive correlation periods of the 20th century.
They may not be directly offsetting losses, but they’re still doing their job.
E-mail your questions to agalbraith@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.