Understanding Market Correlation of Stocks and Bonds
At Pathway Financial we believe that stocks and bonds are more correlated than people think. Market correlation is a statistic the finance and investment worlds often use. It measures the degree to which two securities move in relation to one another.
Most investors have likely heard of the 60-40 portfolio which is 60% stocks and 40% bonds. The 60-40 portfolio is a highly hyped, generalized investment portfolio framework commonly used today. The reason this type of portfolio is highly regarded is that there is a widely held belief that stocks and bonds tend to move in opposite directions. However, this belief is largely false.
Market Correlation in Bonds
It is important to understand that all bonds are diverse. Each distinct class of bonds can perform differently during different times in the economy. Therefore, the investor who wants to use the 60-40 portfolio should have some level of understanding of what types of bonds make up 40% of their portfolio and what kind of risk they hold. Some examples of bonds include:
Treasury Bonds- these are typically the safest
Municipal Bonds- issued by state & local governments
Agency Bonds- issued by Federal Government Agencies (like Fannie Mae)
Investment Grade Corporate Bonds- issued by highly rated corporations
Junk Bonds- issued by poorly rated corporations
Bonds carry different levels of Credit Risk (volatility) based on the issuer of the bond. Investors generally see Treasuries as a safe haven. Agency Bonds are the next in line regarding safety, followed closely by Municipal Bonds. Investment Grade Corporate Bonds are riskier than Treasuries, Agencies, and Muni’s, but Junk Bonds are riskier than their Investment Grade counterpart. There are also International or Emerging Markets Bonds which bring other risks to the table.
Stocks & Bonds During Recessions
Sometimes treasuries are positively correlated; other times they’re negatively correlated. According to PIMCO, during the first half of a recession, stocks and US Treasuries were positively correlated during three of the seven (1970, 1981/82, 1990) recessions from 1969 – 2008. In two of the recessions (2001 & 2008), stocks and treasuries had a negative correlation, or they generally moved in opposite directions. The other two recessions (1973/74 & 1980) there was little to no correlation, meaning they sort of marched to the beat of their own drum.
Some bonds, like corporate bonds, are very correlated (move in the same direction) as stocks, especially during times of market stress. It’s interesting to note that the Federal Reserve has kept interbank lending rates (Fed Funds Rate) really low since the 2008 financial crisis. This might help explain why there were similar amounts of volatility in corporate bonds as in stocks during March 2020.
In March 2020 stocks, corporate bonds (both investment grade and junk), and high yield municipal bonds all experienced similar levels of volatility. The fact these assets were positively correlated, and also experienced similar amounts of volatility, caused many investors some surprise. A very popular 60-40 balanced mutual fund we follow experienced an approximate 23% peak to trough decline between February 19, 2020, and March 23, 2020.
Other risks to bonds include Interest Rate Risk & Inflation Risk. Interest rate risk is more profound when the underlying bond or bond portfolio has a longer maturity. You should measure bond funds with duration. What bonds (more so intermediate to long term treasury bonds) do tend to offer during times of market chaos and stress is lower volatility and usually some positive returns.
Are There Ways to Improve Diversification and Volatility?
Many investors tend to have a recency bias when making investment decisions. Most “seasoned” investors today likely started investing sometime in the 1980s or 1990s. The early 1980s essentially made investing popular through the use of mutual funds, retail stockbrokers, and 401(k) plans. The 1980s served as a starting point for many investors today looking at statistical data for different types of investment classes such as stocks and bonds. In other words, generally speaking, our time reference is somewhat short and only encounters a long term decline in interest rates, which has been a good thing for bond investors.
Investments (including bonds) have evolved so much over the last 40 years. This makes it difficult to look at what the modern bond side of a portfolio that includes treasuries, corporate, agency, international, emerging market, and municipal bonds would have done during the Great Depression, the Post World War Boom Cycle, and the Stagflationary period of the late 1960s through the 1970s. There is plenty of data on US Treasuries during these times, but not so much for the other bond categories.
The 60-40 portfolio has proven it has provided downside insulation during market chaos over the last 40 years. What it doesn’t do is prevent downside risk altogether as evidenced in March 2020. In fact, there is no investment portfolio allocation that accomplishes this. If there were, we’d all invest in it!
Below is a graph that represents 3 different hypothetical investments. The investments represented by the gold and blue lines both tend to rise over time with similar ebbs and flows. The investment represented by the green line is generally flat over time with its own unique ebb and flow. If you could choose to invest in two of the three hypothetical investments, which two would you invest in?
Most people would choose the gold and blue line investments. However, it is the investments represented by the gold and green lines that should be more appealing to the investor who wishes to truly diversify. Other statistical measures, such as volatility, are important to understand when making a final decision. However, if the gold and green line investments are weighted properly and rebalanced somewhat frequently, they can achieve a better return than a portfolio composed of the gold and blue lines while also exhibiting less volatility (risk).
There are two very important keys to this philosophy. First, within the portfolio, there must be investments that move countertrend to one another. The second key is rebalancing the investments over time. Rebalancing causes us to sell some of the investment(s) that performed well and buy some that performed poorly. Rebalancing helps us to follow the #1 rule in investing: Buy low, sell high.
This Concept in Action
At Pathway Financial we are dedicated to not only consistently monitoring stocks and bonds but also to furthering our knowledge on financial planning and investment management as a whole. We know the more we know the more we can best serve our clients. We use the hypothetical investments concept covered above often for our clients. If you’d like to learn more about market correlation and how we can use this concept for your portfolio, call us at (765) 698-5121.