Many investors are forgetting that there’s more to investing in bonds than yield and income.
If that were the only reason, investors could be excused for wanting to reduce their bond allocation right now — if not eliminate it altogether. With bond yields at historic lows on a nominal basis, and even lower (if not negative) on an inflation-adjusted basis, it’s difficult to see how bond investments will produce handsome profits over the next several years.
But there is another major reason to invest in bonds, which is to reduce the volatility of an all-equity portfolio. And the past century shows that this cushioning ability that bonds have is in fact greater when interest rates are lower.
From this second perspective, investors might even want to celebrate today’s rock-bottom rates. Rather than spell the death of the 60/40 stock bond portfolio, perhaps low rates are a reason to redouble our commitment to portfolio diversification.
The chart below provides the historical basis for this view. It shows for each month since 1926 the stock-bond correlation over the subsequent 120 months. The chart also plots for each month where the 10-year Treasury yield stood. Notice that the two data series tend to rise and fall in unison, with higher Treasury yields associated with higher stock-bond correlations over the subsequent decade.
To understand what this means for your portfolio, recall that lower stock-bond correlations are more beneficial. That because it means there’s a greater chance that bonds will rise when stocks fall. Higher interest rates therefore are a double-edged sword. While they mean that bond investments will produce a higher nominal return, those higher rates also mean that a stock-bond portfolio won’t be as low-risk as it would have been had rates been low.
Other factors to keep in mind
Needless to say, this is not the final world on the subject. Researchers have exhaustively analyzed the stock-bond correlation over the decades and have found other factors that influence it besides the level of interest rates.
A helpful introduction to these other factors is an article that was published many years ago in the Journal of Fixed Income, entitled “Stock-Bond Correlations”. Its author was Antti Ilmanen, now global co-head of the Portfolio Solutions Group at AQR Capital Management. He identified several additional factors to keep in mind when trying to forecast whether the stock-bond correlation will be high or low. These include:
- Faster-than-expected economic growth will cause the correlation to be low, or even negative. That’s because the stronger growth will help stocks and hurt bonds.
- Higher-than-expected market volatility will also cause the stock-bond correlation to be low, since that volatility will hurt stocks and help bonds (because of a flight to quality away from stocks).
- Changes in monetary policy and expected inflation will cause the stock-bond correlation to rise, however.
So if economic growth will be faster than expected in coming years, or stock market volatility will be higher than currently anticipated, then the stock-bond correlation should go down. If there will be an unexpected tightening of monetary policy in coming years, and/or if inflation is unexpectedly higher than currently anticipated, then the stock-bond correlation should rise.
As always, nothing is guaranteed in this business. But low interest rates are not, in and of themselves, a good reason to give up on a diversified stock-bond portfolio.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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