Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, May 24, 2022
The S&P 500 Index briefly touched bear market territory (down 20% from peak) intraday on Friday, May 20. While much will continue to be said about where equities are headed, what about bonds? How have bonds performed historically during equity bear markets (as measured by the S&P 500 index), and how have bonds performed historically six months following an equity bear market bottom?
As shown in the LPL Chart of the Day, bonds have historically performed well during equity bear markets, as measured by the Bloomberg US Aggregate Bond Index (Agg), returning over 6% on average. Of the three primary sub-components of the Agg, U.S. Treasuries bonds performed the best (+8.4% on average), living up to their safe haven profile, while corporate bonds, which introduce credit risk, have performed the worst (+2.6% on average).
This year shows a clear divergence in the positive performance from the Agg during equity bear markets (-9.2% as of 5/20). What likely caused this divergence? Compared to the periods shown in the chart below, 2022 is the only period where the 10-year Treasury yielded less than 2% at the start of the equity bear market and inflation was elevated (as measured by year-over-year core CPI). As of January 3, 2022, the 10-year Treasury yielded 1.63%, while core CPI measured 6% in January. Low starting yields and above average inflation has resulted in poor bond performance so far in 2022 as bond yields try to catch up to inflation. In fact, the 10-year Treasury yield has approximately doubled at its year-to-date peak of 3.20%. In contrast, in September of 1976, core CPI measured 6.8%; however, the 10-year Treasury yielded 7.5%.
While 2022 has thus far been a historically painful bond environment based on performance, how have bonds performed the next six months after an equity bear market has bottomed? As shown in the chart below, if the S&P 500 bottoms soon, bonds may be poised to recover some of the 2022 losses. On average, the Agg returned 5.8% during the six month period after equity markets bottomed. And the story reverses looking at the three primary sub-components of the Agg; Treasury bonds performed the worst (+3.6% on average), while corporate bonds performed the best (+10.2% on average). It should be noted that bonds historically provided positive returns following an equity bear market even as equities (S&P 500 index) rallied during the periods shown below. As such, it is not surprising to see corporate bonds outperform Treasuries as risk assets rally broadly given a higher historical correlation to equities.
However, if equities continue to decline, LPL Research believes the rapid rise in rates so far in 2022 will allow bonds to act as a better diversifier to equity volatility moving forward (discussed here). Additionally, if history is an indication of future performance and equities bottom soon, bonds may perform better the second half of 2022 and recover some of this year’s losses. 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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