Bonds and fixed income: Where’s the hedge?

by Derek Horstmeyer, Jason Huddler and Jianyu Ren
Bonds and other fixed-income assets are supposed to offer diversification benefits, especially in rough times. But how have they really performed?

It is no secret that 2022 has been a rough year for pretty much all asset classes across the board.

While US equities have fallen more than 20 per cent, the average fixed-income security has not fared much better: Most are down at least 10 per cent.

Of course, bonds and other fixed-income assets are supposed to offer diversification benefits and provide something of a cushion for when the equity component of a portfolio runs into rough times.

Clearly, they are not performing these functions especially well of late.

With this in mind, we sought to understand when fixed-income assets have actually done what portfolio managers and investors expect them to do.

We looked at returns for the S&P 500 and the average total bond fund going back to 1970 and analysed how the correlations between them have changed over time.

We tested the correlations over different interest rate environments, as well as in changing rate environments.

So, what did we find? With the federal funds rate serving as a proxy, the highest correlation between fixed-income and equity returns has occurred in rising rate environments.

This mirrors the current predicament. As the US Federal Reserve seeks to rein in inflation, bond returns are not ameliorating the equity market losses but are, in fact, falling more or less in tandem with stocks.

Indeed, we find that the correlation between stocks and bonds is lowest in flat interest rate environments.

Whether this is because such environments correspond to the most stable of economic times is an open question.

Nevertheless, whatever the cause, bonds and fixed income seem to offer the most diversification benefits and the least correlation with equities when interest rates are static.

We next examined stock-bond correlations during low, medium, and high interest rate environments, that is when the federal funds rate is below 3 per cent, between 3 per cent and 7 per cent, and above 7 per cent, respectively.

Here, we found that stock and bond correlations are highest when the federal funds rate is above 7 per cent. Conversely, bonds offer the most diversification benefits, or the least correlation with equities, during low rate environments.

Finally, we explored how the benefits of diversification shift during recessions.

To do this, we isolated the correlation between stocks and bonds at the outset of each of the seven recessions that have occurred since 1970, and then compared that to the stock-bond correlation at the conclusion of that particular recession.

In five of the seven recessions, the correlations increased, with the largest spikes occurring during the 1981 recession and in the Great Recession.

What lesson can we draw from this? That it is precisely when fixed income’s diversification benefits are most needed – during a recession – that they are least effective.

This presents a sizeable dilemma for investors and portfolio managers alike.

Amid recession or rising rate environments, we cannot count on fixed income’s hedging effect.

Which means we need to look to other assets classes – perhaps commodities or derivatives – for protection in bear markets.

Of course, they may not be capable of filling the gap either.

Derek Horstmeyer is a professor at George Mason University School of Business, specialising in exchange-traded fund (ETF) and mutual fund performance. Jason Huddler is a senior at George Mason University pursuing his Bachelor of Science degree in business with a concentration in finance and a minor in business analytics. Jianyu Ren is a senior at George Mason University pursuing a Bachelor of Science degree in business with a concentration in finance.

Source: The Business Times