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As advisors know, one of the primary purposes of fixed income exposure is to reduce a portfolio’s correlations to stocks. It’s a big reason why the 60/40 portfolio structure was a gold standard for so many years.
However, the combination of rising interest rates and hot, persistent inflation is eroding some of the previously negative correlations of high-quality bonds to equities, meaning supposedly low risk fixed income instruments are reducing risk in client portfolios as those bonds have in years past.
That’s challenging for advisors because conventional wisdom holds that riskier, lower-rated bonds, say convertibles or high-yield corporates, are most likely to have notable correlations to equities. That’s not supposed to be the case with municipal bonds or Treasuries.
Leave it to the Federal Reserve to throw a wrench in well-intended fixed income plans. The Fed's first rate hike of 2022 arrived last week. Some experts believe another six or seven hikes could be on the way this year. Regardless of what the final tally is, the central bank is signaling rate hikes are necessary to damp inflation and bond markets are reacting.
History Not Repeating
Recent data suggest Treasuries aren’t getting the job done in terms of offering negative correlations to stocks.
“Over the six-month period ended Dec. 31, 2021, only cash and short-term Treasuries managed to exhibit a decent negative correlation with equities,” says Morningstar analyst Christine Benz. “Longer- and intermediate-term government bonds were less effective as diversifiers over that period. Over the whole of 2021, cash and most short-term Treasuries had modest negative correlations with stocks; other bond categories were positively correlated.”
Longer term trends in terms of equity/fixed income correlations are also meaningful and could potentially serve as a starting point of client conversations. Perhaps not surprisingly, over the long haul, it’s been Treasuries and cash that act as the best correlation breakers for stocks.
“Over the past two decades, Treasury bonds have provided the best diversification of any bond type--and indeed of any asset class--for investors with equity exposure in their portfolios. The correlation benefit was similar for Treasuries across the duration spectrum. Cash has been the next most attractive diversifier for stocks,” adds Benz.
Of course, there’s also the matter of fixed income allocations in a new tightening regime. As advisors know, this is a particularly important endeavor in the fixed income space, meaning the importance of this task is amplified for advisors that have large amounts of older clients or those nearing retirement. Still, clients are being pinched by rock-bottom yields on municipal bonds and Treasuries while credit spreads are depressed, indicating the reward for taking on risk above Treasuries isn't what it used to be.
Some Good News
Ultimately, high-quality bonds, though there are no guarantees, should hold up fairly well when equity markets slide and that’s important news for clients investing for the long-term or those in retirement looking to reduce risk.
“The good news for investors is that they don’t need to venture into volatile long-term Treasuries to obtain diversification: Short- and intermediate-term government bonds have been as effective as long, and cash has recently been almost as effective a diversifier as Treasuries,” concludes Benz. “That’s an important finding because long-term Treasuries are substantially more volatile than short- and intermediate-term bonds, while their yield advantage is fairly modest.”
Interestingly, municipal bonds, often a favorite of advisors and clients alike, don’t get the job done in terms of reducing equity correlations. That’s something to ponder.
Related: How Advisors Can Bring Green to Client Muni Positions