A recent paper analyzing the correlation between stock and bond returns going back to 1875 suggests the relationship of the past quarter century is shifting in an uncertain inflationary environment. The results might stimulate some investors to rethink their portfolio allocations.
Researchers at the State of Wisconsin Investment Board and fund manager Robeco take a new look at one of the fundamental drivers of long-term investment risk/return ratios — how much equity and bond prices move together – in “Empirical evidence on the stock-bond correlation,”. The paper adds value to this well-studied area by taking the analysis back nearly a century and a half, and studying the UK, Germany, France and Japan in addition to the US.
Let’s start with the classic “stocks for the long run” argument, which asserts that equity markets will drive the lion’s share of portfolio growth over periods of 10 years or more and will very likely outperform bonds and other asset classes. Investors who accept it take most of their long-term risk in stocks.
But 100% in stocks is too risky for many investors, especially those saving for shorter horizons such as a house down payment, college tuition for children or imminent retirement. The conventional advice for these people is to take some money out of stocks and put it in bonds to reduce risk. But which bonds?
The simplest approach is to use money market funds or Treasury Bills, which can be bought directly from the Treasury with no fees. Since they carry very little risk, their correlation with equities doesn’t matter. They reduce risk because you’re buying less stock.
But most investors choose riskier bonds, such as 10-year or 30-year Treasury securities or corporate or foreign-currency bonds. As long as the correlation of these bonds with stocks is less than one, they offer diversification benefits. Up to a point, the more risk you take with the bonds, the more diversification benefits you get.
From 1970 to 1999, the correlation between Treasuries and stocks in the US was +0.35, making bonds a fair diversifier of equity risk. But since 2000, bonds have had a -0.31 correlation with equities, which makes them better than diversifiers, they can hedge some equity risk. This has offered investors a free lunch — adding bonds to a portfolio can reduce risk, even if you sell no equities. So, you keep all the return on your equities, get the return from the bonds, and have less volatility than before. Bonds do not just dilute equity risk, they eat it.
These correlations apply to Treasuries. Corporate and foreign-currency bonds add some extra risks. Credit risk is highly correlated with equities — bonds tend to default when stocks are down, not up — but the correlation is less than one and many people believe investors are paid a higher return premium per unit of risk for credit risk versus equity risk. Foreign currency risk is more complex.
The negative stock/bond correlation since 2000 means many younger investors and advisors have learned from experience that it makes sense to take a lot of risk in the bond allocation of portfolios, however big or small that allocation is. Can this happy state of affairs be expected to continue?
The authors offer no predictions, but their analysis is pessimistic. Positive stock/bond correlations seem to be the historical norm, and the current US period of negative correlations is the longest ever in any country. Correlations now appear to be creeping up toward zero.
Moreover, negative correlations seem to require low and stable inflation and low real returns on bonds (this is an associational study only, the causality could run in either direction, perhaps low stock/bond correlations cause low and stable inflation and low real returns on bonds). But the US is at least threatening to enter a period of higher (above 4%) and unstable inflation, which should increase the real returns investors demand to hold bonds.
Of course, investors who fear increased and unstable inflation, plus rising real yields, will shun bond risk for short-term tactical reasons. If they keep any fixed-income allocation it will be in money markets, Treasury bills, floating-rate bonds or TIPS. This paper suggests that even when the inflation shark leaves and it’s safe to go back to the bond-risk water, investors might cut back sharply on bond risk for long-term asset allocation reasons.
The correlation between stocks and bonds can seem like an esoteric abstraction for economists and portfolio theorists to meditate over, but it has strong implications for long-term portfolio risk and return, and therefore for investor choices. The rules-of-thumb that have worked for nearly a quarter century may be nearing their sell-by dates.
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