How Bonds Work in a Market Selloff

Written by David Sleigh, CFA, CAIA, FDP, Portfolio Manager

Author Note: This commentary is part of a multi-post series focused on understanding fixed income’s role in balanced portfolios [1]. Here, we attempt to explain what happens to fixed income during periods of equity market volatility and how that impacts balanced portfolios.

Fixed income (a.k.a. bonds) is considered a crucial part of the balanced portfolio equation (using fixed income to help reduce the volatility of equities). So why is this?

Periods of heightened volatility during equity market selloffs have traditionally been accompanied by falling interest rates, which typically drives fixed income prices higher. This can result in a counterbalancing effect for portfolios that are experiencing losses from equities. This is the principle behind why equities and fixed income are combined to create a balanced portfolio.

Figure 1 displays fixed income’s performance (as measured by the Bloomberg Barclays US Aggregate Bond Index) during times of equity market stress, as measured by the S&P 500 Index. The x-axis represents equity market performance, the y-axis represents fixed income market performance, and the size of the bubble measures the length of time that equity markets were falling.

Figure 1: Fixed income performance during equity market downturns. Source: Bloomberg, QA Wealth Management.

It is important to remember that the balanced portfolio equation holds true only so long as equities and fixed income have a low or negative correlation (i.e., they counterbalance one another). Fixed income has generally exhibited negative correlations with equity markets during periods of market duress. However, there is a grouping of red dots where this was not necessarily the case (equity markets fell and so did fixed income). To further understand this relationship, we can look at the rolling correlation (interaction) between equities and fixed income over time.

Figure 2: Rolling 252-day Equity vs. Bond Correlation. Source: Bloomberg

 

Figure 2 displays the rolling 1 year (252-day) correlation between equities and fixed income prices since 1989. Periods highlighted in green represent equities and bond prices moving in tandem (positive correlation), while red represents times they moved in opposite directions (negative correlation). This illustrates the diversification benefit bonds can provide for a balanced portfolio during certain occasions.

During recent equity market downturns, fixed income helped to dampen volatility due to its low correlation to equities. It is important to note that correlations tend to increase for all assets during phases of substantial equity declines (this is represented by significant reversals upwards in Figure 2).

Another important observation about the rolling correlation chart is that the current environment of negative correlations between equities and fixed income has not always held true. For example, in the period leading in to 1998 depicted in the chart, correlation between these two asset classes was positive (when equities went up, fixed income went up, and when equities fell, fixed income fell). These periods are represented by red dots in Figure 1 and by the green positive correlation in Figure 2.

Central takeaway: In recent periods, fixed income has provided diversification benefits for balanced portfolios. However, this does not accurately represent the full history of markets, as equities and fixed income have experienced positive correlation during other market cycles.

What could happen with fixed income if we face a rising interest rate environment? What potential concerns does this pose for balanced portfolios?

In the next part of this series, we will delve further into these questions and their implications for balanced portfolios.

 

 

 

 

[1] For purposes of this article, balanced portfolio will be used as a term for any blended combination of equities and fixed income used in order to dampen volatility.

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Disclosures

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.

The S&P 500 Index is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the New York Stock Exchange or the NASDAQ Stock Market.

An investor cannot invest directly in an index. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns. The index performance results provided in this presentation represent past performance and are not a guarantee of future performance. For additional information regarding these indices, please refer to the sponsor websites at www.bloombergindices.com and www.standardandpoors.com.

Asset allocation or diversification does not ensure a profit or protect against a loss.

 

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