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Is a Bond Allocation Really an Adequate Diversifier?

September 2022
Key Takeaways
1The historically low correlation between stocks and bonds may provide ballast for a portfolio when equity markets decline. But the inverse relationship between stocks and bonds may be more tenuous than many realize.
2With both asset classes having benefitted from the low interest rate environment, there is increased risk they could suffer in tandem as the Federal Reserve raises rates.
3By including solutions that are designed to be uncorrelated to both equity and fixed income, investors may be better equipped to navigate a market environment in which the performance of their entire stock and bond portfolio is correlated to interest rate risk.

In traditional portfolio models, fixed income commands a sizable allocation for one reason: diversification. The historically low correlation between stocks and bonds may provide ballast for a portfolio and reduce drawdowns when equity markets decline.

But the inverse relationship between stocks and bonds may be more tenuous than many investors realize and may potentially be on particularly shaky ground today. That doesn’t bode well from a diversification standpoint and underscores the need for investors to consider adding other asset classes and strategies that have been uncorrelated to both stocks and bonds, to their portfolio.

This article addresses the reasons why fixed income may not be providing the diversification investors expect, and what investors can do to improve portfolio outcomes.


A Look Back: Stocks and Bonds Are Not Always Uncorrelated

For the past 20 years, stock and bond performance has been negatively correlated, but that has not been the case in every market cycle. During the previous 30 years, stocks and bonds were positively correlated.

Stock and Bond Correlation: Negative and Positive Regimes

Stock and Bond Correlation: Negative and Positive Regimes

 

The fact that different correlation environments exist suggests that fixed income shouldn’t be counted on as the only long-term solution for hedging equity market risk. Can bonds still bring the diversification to a portfolio that they have provided in the past?

Recent Periods – Bonds Failed to Provide the Diversification Investors Expect

Recent Periods - Bonds Failed to Provide the Diversification Investors Expect

The Interest Rate Outlook Guides Everything

It is impossible to assign stock market movement to a single factor, but many attribute the stock market’s recent bull run to low interest rates, and it’s even more recent decline to higher interest rates. Surging inflation has contributed to the Federal Reserve’s aggressive stance on raising rates to combat inflation. Recent comments by members of the Federal Reserve have indicated that interest rates should continue to rise and will need to remain elevated in order to bring inflation back down.

The changing composition of standard indices such as the S&P 500 makes stocks even more sensitive to interest rates. In recent years, growth stocks have become a larger segment within the index. Many of these stocks disproportionately benefit from a low interest rate regime because it allows their future earnings to be discounted at lower rates which leads to higher valuations. These high valuations may be particularly vulnerable as investors begin discounting higher interest rates, the cost of borrowing increases, etc.

Equity markets’ sensitivity to interest rates is problematic for portfolio diversification because rates are already one of the biggest risk factors for fixed income. With both asset classes having benefitted from the low interest rate environment, there is increased risk they could suffer in tandem as the Federal Reserve raises rates.

Greater Diversification Is Needed

In response, investors must consider new strategies and asset classes that are uncorrelated to both equity and fixed income. In the past 10 to 15 years, an increasing number of low-correlating strategies and asset categories have opened to individual investors. This provides an opportunity to assemble a dedicated sleeve of non-traditional investments, that are uncorrelated to stocks and bonds, and also uncorrelated to each other.

Importantly, many of these strategies are ‘directionally agnostic,’ meaning they can generate positive returns (or losses) in both falling and rising markets. This means the strategies offer the potential to provide positive performance in times when stocks and bonds lag, but also when they perform well.

By blending these strategies with a traditional equity and fixed income allocation, advisors and their clients may be better equipped to navigate a market environment in which the performance of their entire stock and bond portfolio is correlated to interest rate risk.

 

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