2022 has been a challenging year for asset classes across the board, including bonds and fixed-income investments. While these assets are typically seen as a diversification and cushion during rough times in the equity market, they have not performed as expected. To understand when fixed-income assets have provided the desired benefits, we analyzed the correlations between bond and equity returns.
We examined the returns for the S&P 500 and the average total bond fund from 1970 to the present, considering different interest rate environments. The highest correlation between fixed-income and equity returns was observed during rising rate environments, which is consistent with the current market conditions. As the US Federal Reserve takes measures to control inflation, bond returns have fallen in line with stock losses, failing to provide the expected diversification benefits.
Interestingly, we found that the correlation between stocks and bonds is lowest when interest rates are flat. This suggests that bonds and fixed income offer the most diversification benefits and the least correlation with equities during periods of stable interest rates.
Here are the average stock-bond correlations based on rate environment:
Key Points:
- Rising Rates: 0.5257
- Flat Rates: 0.3452
- Falling Rates: 0.4523
Next, we explored the correlations between stocks and bonds during low, medium, and high-interest rate environments. We categorized these environments based on the federal funds rate: below 3%, between 3% and 7%, and above 7%. The highest correlations were observed when the federal funds rate was above 7%, while bonds offered the most diversification benefits in low-rate environments.
Key Points:
- Above 7%: 0.5698
- Between 3% and 7%: 0.4236
- Under 3%: 0.2954
Finally, we examined how the diversification benefits of fixed income shift during recessions. We compared the correlation between stocks and bonds at the start and end of each of the seven recessions since 1970. In five of the seven recessions, the correlation increased, with the largest spikes seen in the 1981 recession and the Great Recession. This implies that fixed income’s hedging effect is least effective when it is needed the most during economic downturns.
Key Points:
| End of Recession | Start of Recession | Change |
| 0.7930 | 0.7095 | 0.0835 |
| 0.4102 | 0.7569 | -0.3468 |
| 0.6955 | 0.0282 | 0.6673 |
| 0.7807 | 0.5156 | 0.2651 |
| -0.1957 | 0.3754 | -0.5710 |
| 0.8284 | -0.2149 | 1.0433 |
| 0.7364 | 0.3369 | 0.3995 |
This poses a dilemma for investors and portfolio managers. When faced with a recession or rising interest rates, fixed income may not provide the desired hedging effect. Other asset classes, such as commodities or derivatives, may need to be considered for protection in bear markets. However, it is important to note that these alternatives may not fully fill the gap either.
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Note: All opinions expressed in this post are solely the author’s and should not be taken as investment advice. The views expressed do not necessarily reflect those of CFA Institute or the author’s employer.
Image credit: ©Getty Images/ Alphotographic
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