Bonds have gotten a bad rap lately. It’s understandable. Last year was a terrible year for the bond market, with the Bloomberg U.S. Aggregate Bond Index, the key benchmark for bond returns, posting a painful 13% loss. And while that was certainly not an ideal scenario for bond investors, the hardest pill to swallow was the fact that the decline coincided with a significant drop in the stock market, with the S&P 500 also down double digits at 18%. It left some questioning the role of bonds as ‘the great diversifier’ that is often used to protect balanced portfolios when stocks—or equities—fall.

Though it’s true that bonds didn’t serve investors as well as usual last year, at LCM, we still believe in the power of bonds. Even after a disappointing 2022 for bond investors, now is not the time to throw out the baby with the bathwater! Our goal has always been to grow and protect our clients’ assets. With that in top of mind, here are the key reasons we still believe that including bonds is key to the long-term growth of our balanced portfolios:

• The normal relationship between bonds and equities was challenged by unexpected inflation—which led to higher interest rates.
  Last year was anything but normal. By their nature, stocks and bonds tend to exhibit low or negative correlation. In most cases, when one goes up, the other goes down—and vice versa—and stocks and bonds rarely fall together. This is precisely why bonds are used as a diversification tool within balanced portfolios. But during the challenging market environment of 2022, the correlation between stocks and bonds rose significantly. This shift was caused by unexpected inflation, which caused the Fed to respond by raising interest rates. Because sharp increases in interest rates are inherently detrimental to both stock and bond prices, the two asset classes moved in the same direction.

  

  Federal Funds Rate^[1]

  Though interest rates will inevitably rise and fall over time depending on a variety of economic factors, studies show that the correlation between stocks and bonds tends to remain relatively low (or negative) during ‘normal’ periods of steadily rising and falling interest rates. And conversely, when rising rates are the result of an economic shock, such as unexpected inflation, stock-bond correlations rise. This is exactly what occurred in 2022.

• As inflation and the Fed-driven higher interest rates normalize, the correlation between stocks and bonds is also likely to normalize.
  What is ‘normal’ when it comes to this magical correlation between stocks and bonds? To put the situation into context, 2022 was the first time both stocks and bonds suffered double-digit losses in the same year since 1969! As illustrated below, the correlation of stocks and bonds over the previous 30 years was 0.13. However, while measuring at higher frequency, the 3-year measure was 0.61—significantly higher than investors have experienced since the 1990s.

  

  30 Years of Stock-Bond Correlation^[2]

  As we look ahead to the remainder of 2023 and beyond, it is likely that inflation will continue to decline. Already, both headline and core CPI inflation have trended down from their recent highs, and as the chart below shows, the Fed’s attempts to quash runaway inflation appear to be working. From an investor’s perspective, this tells us that the Fed may finally be ready to ease off on rate hikes and eventually begin to reduce rates gradually over time . When that happens, the combination of lower inflation and (hopefully) lower interest rates should push stocks and bonds toward a more typical correlation.

  

  CPI Inflation Since 2020^[3]

  That is not mere conjecture: data supports this hypothesis. The next figure measures stock-bond correlation at a higher frequency (rolling 50 days). As the graph shows, that correlation spiked at a high of 0.57 in early December 2022, and by February 16, 2023, it had already fallen dramatically to 0.24. But then February provided some strong economic data, with both retail sales data (which is used to measure economic activity) and inflation coming in above expectations. This gave the Fed more cause to keep interest rates elevated. As a result, both stocks and bonds reversed course, increasing correlation once again and putting an end to the rally that kicked off the year. As the markets try desperately to predict the future path of interest rates, and as statistically noisy economic data comes in, investors should prepare for and expect volatility in asset prices.

  

  Short-term Stock-Bond Correlation over the past year^[4]

• When the ‘flight to quality’ occurs in times of market risk, bonds tend to appreciate.
  Another plus for the future of bonds is the predictable pattern of investors overwhelmingly selling risk (stocks) and buying safety (often US Treasury bonds) during times of market uncertainty. In this case, it’s a simple matter of supply and demand. The more stocks are sold, the more stock prices drop. And the more Treasuries and other bonds are bought, the more bond prices rise. When this happens, bonds perform in the way we expect them to: they appreciate in the face of depreciating stocks, dampening losses to the overall portfolio. Even in the context of shifting stock-bond correlation, the ‘flight to quality’ effect is relatively reliable.

• The total return on bond investments is often more beneficial than it may seem.
  There are times when holdings in bond mutual funds may show an unrealized loss. Keep in mind, however, that unrealized losses consider only the price of the bond fund versus the price at which it was originally purchased. This figure does not capture the interest income that has been received by holding the fund. Often, the total return of the investment is positive—even when a statement shows the position at a loss. When this happens, investors may see an added benefit of being able to sell the position for a tax loss (in taxable accounts) to help manage capital gains taxes over the course of a year.

Our goal, always, is to help grow and protect your wealth , and each of these factors points to the power of including bonds to reduce the risk within a balanced portfolio. Despite what we saw in 2022, core bonds are inherently lower risk investments than stocks. Even ignoring correlations and the power of diversification, by shifting assets from a higher risk investment (stocks) to a lower risk investment (bonds), the average risk of the portfolio drops. It’s that simple.

Plus, while investors who had bond exposure at the start of 2022 experienced negative returns due to rising interest rates, assets invested in bonds in 2023 are likely to earn a higher yield due to the higher starting point in yields (and lower interest rate risk!). With interest rate risk accounted for, a bond investor could move on to consider credit risk. We have not seen a material increase in credit risk thus far, largely because most companies have been able to refinance to reduce the cost of their debt, making them less likely to default on interest payments or maturity payments.

We believe bonds remain ‘the great diversifier,’ and we will continue to balance—and rebalance—our portfolios to manage your investment risk by maintaining an appropriate weight of each asset class according to your investment strategy. (Read more on the art of rebalancing here.) Life is unpredictable, but in the world of investing, we believe some things, including the diversification power of bonds, will always hold true.

[1]  Federal Funds Rate, Source: Bloomberg
[2]  Stock-bond correlation is calculated using monthly returns for the S&P 500 Index and the Bloomberg Barclays U.S. Aggregate Bond Index. Rolling 36-month figures are graphed, as well as the correlation for the entire period: 2/29/1996-2/28/2023. Source: Bloomberg
[3]  Inflation is represented using the Consumer Price Indices (Core & Headline) produced by the U.S. Bureau of Labor Statistics. Period measured is 12/31/2020-1/31/2023. Source: Bloomberg
[4]  Stock-bond correlation is calculated using daily returns for the S&P 500 Index and the Bloomberg Barclays U.S. Aggregate Bond Index. Rolling 50-day figures are graphed, for the entire period: 2/28/2022-2/28/2023. Source: Bloomberg

← Back to Insights