Tuesday, May 17, 2022
One of the value propositions of owning core bonds is that they tend to act as a diversifier during equity market drawdowns. That is, core bonds have tended to outperform equities during equity market selloffs, which has helped cushion total portfolio volatility and helped mitigate losses (versus a 100% equity portfolio). However, that has certainly not been the case so far this year as equities (as defined by the S&P 500) and core bonds (as defined by the Bloomberg Aggregate index) have both experienced double-digit losses (at the time of this writing, however, core bonds have lost slightly less than 10%). With such deep losses for each asset class coming at the same time this year, investors may be left wondering if the diversification benefits of core bonds are over.
However, as shown in the LPL Chart of the Day, since 2000, the correlation between stocks and bonds has generally been negative, although there has been considerable variation with that relationship. And at times, the relationship between stocks and bonds has, in fact, been positive (from 1965 to 2000, correlation was actually slightly positive due to higher inflation and more frequent inflationary shocks). So, as was pointed out in our blog post on Friday May 13 (found here), the historical correlation between stocks and bonds is actually close to 0– meaning it’s generally noisy. So, in other words, it isn’t that uncommon to see equity and bond prices moving lower (or higher) at the same time.
That said, now that interest rates have moved off the all-time lows set back in August 2020, there is more of a cushion to act like a diversifier during equity market drawdowns, which is what we’ve seen during the most recent equity market stresses over the past few weeks. Since the start of May, equities are down over 3% whereas core bonds are slightly positive. And without any additional macroeconomic shocks driving the divergent returns, it’s comforting to see bonds providing that equity buffer, albeit over a very short time horizon. “The back-up in yields this year has certainly been painful, but the ability for fixed income to act as an equity buffer has increased, in our view,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “As bond and equity markets both move past the aggressive repricing of Fed rate hikes that have caused both markets to sell off this year and grapple with a potential slowdown in economic growth, bonds are likely to provide that safety net to portfolios again as we move through the year.”
So what does this say about core bonds? While we’re not saying yields can’t go higher from current levels, with improved valuations (see here) and the potential for core bonds to provide diversification to equity risk again, this could be a good time for investors with a meaningful underweight to core bonds to reevaluate their allocations to the asset class.
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