Bonds have for a long time been the most important (and sometimes only) diversifier to equity risk in many investors’ portfolios. The traditional 60-40 Equity-Bond portfolio is a great case-in-point. Over the past twenty years investors have benefited from a negative, average correlation between the returns of bonds and equities.
Over longer horizons however, while bonds have traditionally been diversifying to equities, they have typically shared a positive correlation, as shown in the Figure below. If we were to now experience a period of higher correlation between bonds and equities investors should be prepared for higher overall portfolio volatility than what they have been accustomed to.
Source: Jacobi calculations
A different way to show how well bonds have performed as a diversifier to equities is to compare the recent performance of U.S. equities to long duration U.S. Treasury bonds (which we proxy with large, liquid Exchange Traded Funds) in periods of equity market drawdowns.
In the recent periods of equity weakness highlighted on the chart above, long-duration bonds would have acted to offset the losses at portfolio level. Newer investors might have been influenced by this recent performance to think that bonds would always reward them in times of equity market troubles.
With inflation now recording its highest readings in decades and central banks signalling their intention to raise interest rates, long-duration bonds in particular have been hurt as yields have risen. The iShares 20+ Year Treasury Bond ETF is currently in its deepest ever drawdown. Now that equity markets are also falling, investors find themselves in the relatively uncommon position of having both their bonds and equities experiencing meaningful drawdowns.
This recent performance demonstrates a key concept in portfolio construction – diversifying risk is not the same thing as hedging it. Assets that diversify risk can fall at the same time, and investors should fully expect that on occasions they will. Events like this highlight that institutional investors should always be on the lookout for multiple, diversifying sources of return. Evaluating portfolios through the lens of risk factor analysis, under a regime switching modelling approach, or inclusive of non-linear protection strategies are some of the ways they could go about this. Historical analysis can be helpful, but investors must model and be prepared for a range of possible future outcomes. No two drawdowns are ever exactly alike and there is no guarantee that the assets that protected portfolios in the last drawdown will do so again in the next one.
