investment viewpoints

When can bonds still diversify portfolios?

When can bonds still diversify portfolios?
Francis Lee - Senior Vice President

Francis Lee

Senior Vice President
Florian Ielpo, PhD - Head of Macro, Multi Asset

Florian Ielpo, PhD

Head of Macro, Multi Asset

In 2022, high inflation and hawkish statements from the Federal Reserve, led the well-established negative correlation between equities and bonds to reverse. This created a situation where equities fell as interest rates rose, triggering a fixed-income sell-off and challenging the diversification benefits of a multi-asset portfolio. In this weekly edition of Simply put, we ask: in today’s investment landscape, are bonds still a source of diversification?


Need to know:

  • The negative correlation between stocks and bonds has generally persisted for more than 20 years. But in the current economic environment, it is now being challenged by higher rates 
  • The increase in bond yields has led to a greater correlation between bonds and equities, making it more difficult (though not impossible!) for investors to benefit from diversification 
  • However, historically, higher bond yields correspond to more negative correlation during equity downturns.  Hope is not lost


A renowned hedge

The relationship between stocks and bonds has not always been consistent. In general, bonds have served as a hedge against stock-market losses due to their typically low correlation to stocks, at least over the last 25-30 years. This has been to the benefit of multi-asset investors, who have been able to reduce portfolio risks and limit losses in times of market distress by having fixed-income exposure. 

Rising bond yields: a force for correlation? 

Against the current macroeconomic and policy backdrop, equities and bonds alike have started following the same direction. In recent months, US 10-year Treasury rates have climbed and now hover around 4.6%, while equities have declined. More recently, the decline of yields from their recent 5% height has supported an equity rally. 

Does this signal an end to the negative correlation? 

To understand if this is the case, we need to find out if such an increase in bond yields has always corresponded to a heightened correlation between bonds and equities. Figure 1 provides insights into the relationship between US Treasuries and US equities from 1976-2023. The data seem to show a proportional relationship: as bond yields increased, the correlation between bonds and equities also rose. 

As a consequence, the diversification power of bonds diminished for balanced investors like ourselves when rates increased – or so it seems. This begs the question: do bonds provide less of a diversification benefit than widely believed and, perhaps more significantly, less hedging potential during equity drawdowns? 

FIG 1. Bond-equity correlation at different yield levels 

Source: Bloomberg, LOIM at November 2023. For illustrative purposes only. Past performance is not a reliable indicator of future results.

Seeking a negative correlation – when it matters 

To better understand how yields and the bond-equity correlation interact, we first need to differentiate how the relationship plays out between bullish and bearish periods. During bullish periods, seeing a positive correlation between equities and bonds is not a bad thing per se – as long it turns negative during bearish periods. 

Figure 2 shows the correlation between bonds and equities in the worst 10% and 20% monthly periods of returns for equities, where the asset class fell below -2.3% and -4.7% respectively. This makes the picture clearer: higher yields correspond with a greater degree of negative correlation between equities and bonds than lower ones. 

FIG 2. Bond-equity correlations in worst monthly return periods for equities

Source: LOIM, Bloomberg as at November 2023. For illustrative purposes only. Past performance is not a reliable indicator of future results.

A key argument here is the simplistic idea that when yields are high, they have more room to decline than when they are near zero. Hence, when equity returns are negative and bond yields are higher, the correlation tends to be more negative – which is a relief for multi-asset investors.

Simply put, the diversification potential of bonds relative to equities could be higher than expected, despite higher rates.

Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, inflation and monetary-policy are surprises designed to track the recent movements of macroeconomic factors driving the markets. 

For the past week, they currently show:

  • Growth declined, mainly as a reflection of deteriorating US data
  • Inflation remained steady, still showcasing low-yet-rising inflationary pressures 
  • Monetary-policy developments remain moderate, hovering between hawkish and dovish


World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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