Advisors are acutely aware that fixed-income investment performance has withered in recent years, giving the asset class a new, diminished status. Less well known are signs that bonds have lost their mojo as negatively correlated diversifier against equity risk.
Advisors are hearing about pain aplenty from clients about shrinking yields. But many of these clients aren’t aware that, along with miniscule yields, an increased correlation with stocks is rendering obsolete the traditional 60-40 stocks-to-bonds asset allocation, which had become etched in stone from the 30-plus-year bull market in bonds. Trends now coming into view are like sandpaper erasing deeply etched notions about asset allocation.
These trends lie beneath paltry bond yields, with the Bloomberg Barclays US Aggregate Bond Index yielding about 1% in late August. Of course, this malaise is no less evident in the 10-year Treasury. With yields slightly over 60 basis points in recent weeks—and real yields below negative 1%—the 10-year is losing its classic reputation as an effective hedge against a falling stock market and provider of steady, low-risk income. And now, things are so dire in the fixed-income world that some investment firms are waiving their fees on money funds to keep clients’ nominal yields above zero.
By contrast, when stocks plummeted in 1987, the 10-year Treasury cushioned the fall with a yield of 10%. And when the financial crisis struck in the fall of 2008, at least it was yielding 3.5%.
One factor suppressing yields in recent years has been the stock market fears of individual investors still scarred from the financial crisis of 2008. Paranoid that stocks could go off a similar cliff, these investors have diminished bond yields by fleeing into them from stocks.
Though they’re not getting good yield, these investors figure, at least they’re getting protection from a stock market rout. Or are they?
Growing Correlation
The reality is that, as both bonds and stocks have benefitted from declines in prevailing interest rates, they’ve acquired more long-term correlation. History shows that the degree of correlation between stock returns and bond yields changes widely over long periods. After decades of positive correlation, the pendulum swung back to negative in the early 90s, giving investors in that bull market an obvious way to diversify. Yet there’s evidence that this negative correlation began to decline at the turn of the century, perhaps out of uncertainty over inflation and real interest rates. So even as the case for using bonds to diversify portfolios was gaining strength, its economic underpinnings were already starting to weaken. In recent years, this correlation has increased.
And now, returns of the behemoth tech stocks driving the market are trading more or less in tandem with bonds. So if a client’s shares of Facebook or Apple (or those of an S&P 500 index fund dominated by them) go south, bonds offer little in the way of a reliable cushion.
As recently as a year ago, who could have foreseen yields being pushed down even lower by the black swan event of the coronavirus’ economic impact, making bonds a less effective hedge against equities? If interest rates rise 1 or 2%—an entirely likely prospect over the next year or two—this would savage bondholders.
So clients need to understand the futility of risking principle for yields below 1%. And adding insult to injury, this scenario involves significant opportunity costs.
Absolutely Nothin?
A paraphrase of Edwin Starr’s classic song about war comes to mind: “Bonds, what are they good for?” Whether you reach the same conclusion as the song—“absolutely nothin”—may depend on whether you expect positive correlation to continue. Yet, as periods of negative and positive correlation have historically run for decades, change in the status quo is unlikely anytime soon.