Understanding the correlation between stocks and bonds

What is correlation?

In the world of investing, correlation is a vital metric that offers insight into how the prices of two or more securities or asset classes move in relation to one another. Understanding this measure is essential for investors as it can shed light on the merits of multi-asset portfolios and help gauge the level of diversification within a portfolio.

Correlation is measured on a scale from -1 to 1, providing a qualitative assessment of the relationship between different assets or securities. A high positive correlation indicates that the assets tend to move in the same direction, while a high negative correlation suggests that they tend to move in opposite directions. A correlation of 0 indicates no linear relationship between the price movement of the assets.

Assessing the correlation between different asset classes is critical for effectively managing risk and optimizing returns. As two core components of a well-diversified portfolio, understanding the correlation between stocks and bonds is an essential element of portfolio construction. 

How does correlation between stocks and bonds affect a portfolio?

The correlation between stocks and bonds is an important measure, as these asset classes can potentially serve as a natural hedge against one another, enhancing diversification and mitigating overall portfolio risk. Their tendency to have a low correlation is because equity and fixed income have different drivers of return, meaning their prices don’t typically move in sync with each other.

Equities typically trend upward during times of economic growth, driven by strong corporate earnings, increasing revenues, positive economic data, and overall market optimism. In this type of market environment, central banks may tighten monetary policy, helping to dampen growth by raising interest rates and increasing borrowing costs for businesses and consumers. Interest rates are the main return driver for fixed income and their inverse relationship with bond prices means that rising interest rates will pull bond prices down, leading to negative returns.   

The opposite is also true. Equities tend to fall during economic downturns, when there is uncertainty about future economic conditions or during periods of geopolitical instability. As the economy slows or contracts, monetary policy may loosen, lowering interest rates and boosting bond prices.

By allocating to both equities and fixed income, investors can potentially reduce the portfolio’s overall volatility, cushioning the impact of market downturns while providing a more stable overall return profile.

Do high-yield bonds have a stronger correlation to equities?

While it’s generally true that fixed income has a lower correlation to equities, investors should recognize that certain parts of the fixed-income market may have a stronger correlation. The performance of high-yield bonds, issued by companies with below-investment-grade credit ratings, is often more aligned with equity market returns, limiting the potential for diversification. This is because high-yield bond performance is closely tied to the overall economic environment and the financial health of the issuing companies.

Like equities, high-yield bonds tend to perform well during periods of economic expansion but could experience negative performance during economic downturns or periods of financial stress. This is partly due to increased default risk as economic growth slows or contracts and is also driven by the behavior of high-yield credit spreads, which represent the additional yield investors require for holding these lower-quality securities.

In risk-off environments, high-yield credit spreads typically widen due to the perceived risk associated with these securities. This can weigh on high-yield bond performance just as equity markets are facing headwinds, limiting their ability to smooth volatility and enhance risk-adjusted returns. 

What are the benefits of using high-quality fixed income for diversification?

High-quality segments of the fixed-income market have historically offered significant diversification benefits for U.S. equities. Unlike high-yield bonds, which are primarily influenced by credit risk, the performance of high-quality fixed income is mainly driven by the movement of interest rates. As a result, their performance often moves independently from that of stocks, reducing their correlation and offering a potential buffer against stock market volatility. 

Source: Bloomberg, data as of 7/30/24. See index definitions in disclosure. You cannot invest directly in an index. Past performance does not guarantee future results.

High-quality bonds can offer a safe and predictable income stream even in challenging market environments, solidifying their status as a safe haven asset. When investors shift toward safer assets amid an economic downturn, this flight to safety can push down yields and lead to the potential for price appreciation as well.

Some caveats

Correlations between asset classes aren’t fixed and can fluctuate over time, and historically, have tended to increase during periods of economic stress. This phenomenon was evident during 2022 when soaring inflation caused the U.S. Federal Reserve to aggressively tighten policy, leading to the largest drawdown for bonds on record and coinciding with a double-digit decline in equity markets.

Despite these short-term fluctuations, high-quality bonds still offer some of the best diversification potential relative to equities. Presently, high-quality bonds offer attractive yields that remain above their long-term average. In the event of an economic downturn, investors can likely benefit from this income stream while also seeing potential for price appreciation due to falling yields.

Active management can also offer greater potential for diversification due to the portfolio team’s ability to adjust holdings based on their assessment of the economic outlook. A skilled management team can seek to add value through security selection and sector allocation, capitalizing on opportunities within the fixed-income market throughout the credit cycle.

Understanding stock-bond correlation is a key concept for investors aiming to construct a well-diversified portfolio and effectively manage risk. To enhance portfolio returns and mitigate the impact of an economic downturn should one arrive, we believe that investors should consider an actively managed strategy that prioritizes higher-quality areas of the fixed-income market.