Bonds are traditionally thought of as the asset class that provides downside protection during an equity market correction. But do bonds really provide protection when investors need it most?
“Diversification, the way we typically think about it, is a myth,” said Sebastien Page, head of asset allocation at T Rowe Price, participating in a panel discussion at our sister publication Expert Investor’s Pan-European Congress in Rome on Wednesday.
Page has done some research on the matter in the past and found that bonds indeed provide diversification, but only if equity markets don’t crash.
“Correlations between equity and fixed income tend to go up and down,” he said.
Page found a slightly negative stock/bond correlation when equity markets went up by more than a standard deviation. However, in strongly downward markets correlations go the other way, reaching a positive correlation of 71% in periods when markets are down by more than a standard deviation.
For investment grade credit, the correlation even goes as high as 91%, said Page.
“In the past you had cushion from your coupon that gave you some protection, but with yields so low, that has also stopped,” Tim Peeters, head of securities portfolios at the Belgian multi-family office Portolani, added grimly.
The stock/bond interplay
Sometimes, however, stocks and bonds are good diversifiers. That was for example the case at the from the aftermath of the dotcom boom until the global financial crisis unfolded in 2007, notes Page. What factors drive the correlations between stocks and bonds?
“I would say that you should expect a positive correlation if concern about rates dominates markets. If inflation concerns are absent and if the business cycle dominates news, expect bonds to be a good diversifier, though the problem is now of course that bond yields can’t go much lower even if equities are hit.”
At this point in the cycle, therefore, bonds can offer some capital protection at best. They are unlikely to provide any compensation for losses on the equity side of your portfolio.
Weathering the storm
So, if bonds are no longer the fortifications that help you weather a storm, how can you weather-proof your portfolio instead?
Commodities such as gold are one of the building blocks you can add.
As Peeters puts it: “Not to invest in gold now is like reading a playboy without any pictures.”
“You can also work with multi-asset funds with low volatility, and add long/short equity funds to your portfolio,” he added.
And, last but not least, numerous alternative asset classes have sprung up within fixed income over the past few years: such as catastrophe bonds, mortgages, loans and microfinance.
Although they are often less liquid than mainstream bonds, such strategies tend to couple higher yields with a lower correlation to mainstream fixed income and equity markets.
