Practical analysis for investment professionals
03 November 2022

Bonds and Fixed Income: Where’s the Hedge?

It is no secret that 2022 has been a rough year for pretty much all asset classes across the board. While US equities have fallen more than 20%, the average fixed-income security hasn’t fared much better: Most are down at least 10%.

Of course, bonds and other fixed-income assets are supposed to offer diversification benefits and provide something of a cushion for when the equity component of a portfolio runs into rough times. Clearly, they are not performing these functions especially well of late. With this in mind, we sought to understand when fixed-income assets have actually done what portfolio managers and investors expect them to do.

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We looked at returns for the S&P 500 and the average total bond fund going back to 1970 and analyzed how the correlations between them have changed over time. We tested the correlations over different interest rate environments as well as in changing rate environments.

So, what did we find?

With the federal funds rate serving as a proxy, the highest correlation between fixed-income and equity returns has occurred in rising rate environments. This mirrors the current predicament. As the US Federal Reserve seeks to rein in inflation, bond returns are not ameliorating the equity market losses but are, in fact, falling more or less in tandem with stocks.

Indeed, we find that the correlation between stocks and bonds is lowest in flat interest rate environments. Whether this is because such environments correspond to the most stable of economic times is an open question. Nevertheless, whatever the cause, bonds and fixed income seem to offer the most diversification benefits and the least correlation with equities when interest rates are static.

Average Stock-Bond Correlation by Rate Environment

Rising Rates0.5257
Flat Rates0.3452
Falling Rates0.4523

We next examined stock-bond correlations during low, medium, and high interest rate environments, that is when the federal funds rate is below 3%, between 3% and 7%, and above 7%, respectively. Here, we found that stock and bond correlations are highest when the federal funds rate is above 7%. Conversely, bonds offer the most diversification benefits, or the least correlation with equities, during low rate environments.

Stock-Bond Correlations in Different Federal Funds Rate Environments

Above 7%0.5698
Between 3% and 7%0.4236
Under 3%0.2954

Finally, we explored how the benefits of diversification shift during recessions. To do this, we isolated the correlation between stocks and bonds at the outset of each of the seven recessions that have occurred since 1970 and then compared that to the stock-bond correlation at the conclusion of that particular recession. 

In five of the seven recessions, the correlations increased, with the largest spikes occurring during the 1981 recession and in the Great Recession. 

What lesson can we draw from this? That it is precisely when fixed income’s diversification benefits are most needed — during a recession — that they are least effective.

Stock-Bond Correlations during Recessions

End of RecessionStart of RecessionChange
November 1973 to March 19750.79300.70950.0835
January 1980 to July 19800.41020.7569-0.3468
July 1981 to November 19820.69550.02820.6673
July 199 to March 19910.78070.51560.2651
March 2001 to November 2001-0.19570.3754-0.5710
December 2007 to June 20090.8284-0.21491.0433
February 2020 to April 20200.73640.33690.3995

This presents a sizeable dilemma for investors and portfolio managers alike. Amid recession or rising rate environments, we cannot count on fixed income’s hedging effect.

Which means we need to look to other assets classes — perhaps commodities or derivatives — for protection in bear markets. Of course, they may not be capable of filling the gap either.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Derek Horstmeyer

Derek Horstmeyer is a professor at George Mason University School of Business, specializing in exchange-traded fund (ETF) and mutual fund performance. He currently serves as Director of the new Financial Planning and Wealth Management major at George Mason and founded the first student-managed investment fund at GMU.

Jason Huddler

Jason Huddler is a senior at George Mason University pursuing his bachelor of science degree in business with a concentration in finance and a minor in business analytics. He is interested in financial markets, mergers and acquisitions, and financial modeling. He is currently a candidate for the Beta Alpha Psi honors society.

Jianyu Ren

Jianyu Ren is a senior at George Mason University pursuing a bachelor's of science degree in business with a concentration in finance. She is interested in financial markets, financial analysis, firm valuation, and portfolio management. She will be working towards obtaining her CFA charter after graduation.

4 thoughts on “Bonds and Fixed Income: Where’s the Hedge?”

  1. Stephen Aust says:

    This is the most clearly written article that I’ve ever read. Short. Concise. Great. Thanks.

  2. Krzysztof Kajetanowicz says:

    Agree with Stephen. A simple set of hypotheses and a solid argument. Obviously I’m left curious as to why different recessions have displayed different changes in correlation – or if it’s random.

  3. James Rich, CFA says:

    I think you would find somewhat different results if you used U.S. Treasury bonds.

    Most actively-managed bond funds tend to reach for yield through lower investment-grade corporate bonds. These do tend to track U.S. stocks more closely than U.S. Treasuries – particularly when stocks do poorly.

    1. KY says:

      I share the same thoughts as James Rich, as the results might be different if US Treasuries or Developed Market Government Bonds indices/funds (US Treasuries, JGBs, Gilts, Bunds, etc.) were used. I will be curious to know the results.

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