Analyzing Bond Performance In Stock Corrections

The three bars on the left show the historical volatility of different portfolios using the long-term stock/bond correlation of +0.20. The bars to the right show the same portfolios, but using the -0.55 stock/bond correlation since 2000.

For example, the grey bar in the middle is for a portfolio 60% in stocks and 40% in bonds. This portfolio’s historic annual volatility has been 10%, but it’s only been 8% when stocks and bonds were more negatively correlated.

Source: GMO

Correlations increasing is not the end of the world. Correlation doesn’t tell you anything about the relative performance between stocks and bonds. Returns, not correlations, are what investors actually earn.

The table below shows that bonds have historically provided positive returns even during periods of positive correlations to stocks. That said, the bond returns below were all in periods when bonds offered higher yields and thus more of an income buffer.

Source: PIMCO

Credit Risk

Trillions of dollars in index funds track the Bloomberg Barclays U.S. Aggregate Bond Index. Just one fund, Vanguard’s Total Bond Market Index, manages $215 billion. The aggregate index itself is a blend of investment-grade U.S. government, corporate, and mortgage-backed securities.

The average yield spread of this index (over risk-free Treasuries of a comparable maturity) has historically been 0.78%. On the surface you’d expect that this increase in yield was captured by bond investors for taking credit risk.

Source: Kessler Investment Advisors

The reality is that the aggregate index has only outperformed regular U.S. Treasuries by 0.15%.

Source: Kessler Investment Advisors

Corporate bonds represent 25% of the aggregate index. Both corporate bonds and stocks are tied to corporate profits and the business cycle. Since they’re related, corporate bonds tend to hurt your portfolio when you need bond help the most.

This corporate bond exposure is even more relevant today since the U.S. corporate bond market’s credit quality has weakened. The white line below shows the percentage of BBB bonds in the U.S. investment-grade corporate debt market. BBB is the lowest investment-grade credit rating before debt is downgraded to junk.

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Disclaimer: MVMT Capital LLC (“Movement”) is a registered investment adviser located in Jackson, MS and is registered in the state of Mississippi. Movement may only transact business in ...

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