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Portfolio Construction
Chitrang Purani
Anmol Sinha
When stocks zig, bonds are supposed to zag. That time-honored relationship has broken down over the past few years, but there are encouraging signs of its eventual return.
There’s no doubt that it’s been a challenging environment for fixed income. Losses in 2022 were particularly steep. It marked the first year in decades that bonds fell alongside stocks. Rapid rate increases by the US Federal Reserve (Fed), against a backdrop of some of the highest inflation rates the US economy has experienced in more than 40 years, caused massive upheaval. A look at the correlation between stocks and bonds during equity correction periods since 2010 shows just how unusual a period it was.
Unlike other recent equity corrections, bonds buckled alongside equities in 2022
![This chart shows the stock-bond correlation during equity market corrections. The Y-axis shows correlation from –0.80 to 0.40 while the X-axis shows eight equity market correction periods. The correlations for the corrections are as follows: Flash crash: –0.59%; U.S. debt downgrade: –0.57%; China slowdown: –0.37%; Oil price shock: –0.26%; U.S. inflation/rate scare: –0.08%; Global selloff: –0.26%; COVID-19 pandemic: –0.28%; Historic inflation and rate hikes: 0.23%.]](https://static.capitalgroup.com/content/dam/eacg/en/2023/q4/how-to-use-bonds-for-balance-as-fed-hikes-wind-down/chart-article-balanced-correlation-767x431.png)
Source: Morningstar. As of 31 October, 2023. Correlation is a statistic that measures the degree to which two variables move in relation to each other; a positive correlation implies that they move together in the same direction while a negative correlation implies that they move in opposite directions. Correlation figures based on returns data for the S&P 500 Index versus the Bloomberg US Aggregate Index. Correlation shown for the eight equity market correction periods since 2010. Corrections are based on price declines of 10% or more (without dividends reinvested) in the unmanaged S&P 500 with at least 75% recovery. Dates for correction periods are as follows: Flash crash, April 2010 to July 2010. US debt downgrade: April 2011 to October 2011. China slowdown: May 2015 to August 2015. Oil price shock: November 2015 to February 2016. US inflation/rate scare: January 2018 to February 2018. Global selloff: September 2018 to December 2018. COVID-19 pandemic: February 2020 to March 2020. Historic inflation and rate hikes: January 2022 to October 2022. Past results are not predictive of results in future periods.
But as those rate hikes recede into the rearview mirror and markets increase their focus on the growth backdrop, fixed income may resume its role as a ballast in portfolios. In addition, higher starting yields mean higher return potential for bonds.
“This Fed hiking cycle has been the quickest that we've seen in decades, and it’s likely we’ll see interest rate sensitive segments of the economy soon experience challenges as a result,” says Chitrang Purani, fixed income portfolio manager. “Economic weakening should generally be positive for bonds, both from the standpoint of absolute returns and diversification from equities.”
What went wrong?
The large increase in inflation and inflation expectations during 2022 drove a complete shift in expectations for Fed policy — both on the part of monetary policymakers and investors. In 2023, the year started off with optimism for bond returns as investors eyed relatively high starting yields. Yet the Bloomberg US Aggregate Index has struggled to post gains this year as well, returning 0.40% through 14 November.
The Fed’s actions have continued to loom large, as it raised rates by a total of 100 basis points this year — a slowdown from a 425-basis-point increase in 2022, but still higher than the Fed and markets expected coming into 2023. Although headline inflation has fallen dramatically from a peak of 9.1% in June 2022, it remains elevated at 3.2% as of October. Meanwhile, a much more resilient US economy has led to continued shifts in expectations for not just the federal funds rate but interest rates across the maturity spectrum. A robust labour market, high pandemic-era savings and government stimulus are among the factors behind the economy’s resilience.
Resilient growth and still elevated inflation have adjusted the Fed’s rate expectations
![This chart plots projections for the year-end federal funds rate. The x-axis lists the years 2023, 2024 and 2025; the y-axis lists rates from 3.0% to 6.0%. There are four data sets plotted from Fed meetings in December 2022, March 2023, June 2023 and September 2023. The fed funds rate, as of November 2023, is listed at 5.5%. In December 2022, expectations are plotted as follows: 5.1% for 2023, 4.1% for 2024, 3.1% for 2025. In March 2023, expectations are plotted as follows: 5.1% for 2023, 4.3% for 2024, 3.1% for 2025. In June 2023, expectations are plotted as follows: 5.6% for 2023, 4.6% for 2024, 3.4% for 2025. In September 2023, expectations are plotted as follows: 5.6% for 2023, 5.1% for 2024, 3.9% for 2025.”]](https://static.capitalgroup.com/content/dam/eacg/en/2023/q4/how-to-use-bonds-for-balance-as-fed-hikes-wind-down/chart-article-balanced-fed-funds-767x465.png)
Source: Federal Reserve. As of 13 November, 2023. Year-end projections pulled from Federal Open Market Committee statements released on 14 December, 2022; March 22, 2023; 14 June, 2023; 20 September, 2023. Fed funds rate shown is the upper limit of the fed funds rate.
When can bond investors breathe easy again?
The Fed has opted to skip rate hikes for its last two meetings, with Chair Jerome Powell reiterating that the agency will proceed “carefully” on future actions. He noted that the Fed has been watching a recent increase in longer term yields and that persistent changes in broader financial conditions could impact the path of monetary policy. This likely indicates that the Fed is at least close to done with its hiking cycle.
“It’s been easier for inflation to fall from peak levels last year to near 3% now than it will be to see it come back down to the Fed’s 2% target,” Purani says. “Given growth has been more resilient than most expected, interest rates are likely to remain ‘higher for longer,’ and that’s been reflected in the market this year.”
The higher-for-longer view anticipates that rates, while not necessarily rising much further, may stay at elevated levels for an extended period.
The additional repricing of interest rates higher in 2023 has created a more favorable risk/return balance for fixed income relative to a year ago. Returns are being aided by relatively strong starting yields, which recently touched a roughly 16-year high on the Bloomberg US Aggregate Index.
“After the end of previous Fed hiking cycles, bonds have typically posted strong returns in the subsequent 12 months from a total return standpoint,” Purani explains. “That's historically been a good time to buy into fixed income.” Higher starting yields on their own may support an attractive return profile, but bonds have the potential to diversify against equity volatility with even stronger returns should economic growth materially deteriorate.
In the past four cycles, returns on the Bloomberg US Aggregate Index have averaged 10.1% in the 12-month period following the Fed’s last hike. Current index yields have also closed the gap with three-month US Treasury bills, which may cause investors to rethink holding cash-like investments in favor of bonds with greater interest rate exposure.
“Monetary policy lags seem longer this time around,” Purani says. “But if rates remain high, I believe it's more of a question of ‘when,’ not ‘if’ we’ll see economic weakness.”
That positive correlation of bond returns and stock losses in 2022 has left some investors questioning the value of rebuilding a fixed income allocation. Usually, correlation that is low/near zero indicates diversification, but that relationship was strained against the backdrop of sharply accelerating inflation and shifting monetary policy. However, a more benign outlook for inflation may enhance diversification going forward.
“When inflation is both high and rising, correlations tend to increase between bonds and equities,” Purani adds. “As inflation stabilises or falls, bonds may act as a more reliable diversifier against equity weakness, even if inflation remains at somewhat more elevated levels than in the past decade.”
Where to focus in fixed income
Purani believes the risk of interest rate exposure in portfolios is better balanced. Duration, which measures a bond fund’s sensitivity to interest rates, could shift from a headwind to a tailwind for bond returns over the next year if rates are near their peak. Investors with a higher allocation to equities or other risky assets may want to increase their duration exposure, given better compensation today for rates exposure and the potential for price appreciation should the Fed cut rates in response to an economic downturn.
“Another consideration for investors to help make portfolios more resilient involves the credit quality of their bond investments,” Purani says. “Higher quality credits can be more insulated from economic weakness than their lower quality counterparts, which may be more likely to feel the effects of tighter monetary policy — and investors can add high-quality exposure without giving up much yield.”
“It’s important to understand what you’re getting from your bond fund as many strategies that are benchmarked to diversified bond indices in theory may really be credit portfolios in practice,” Purani adds. “These funds may provide healthy yield if markets trend sideways, but they may correlate more with equities on the way down.” Looking at longer term historical return patterns during periods of equity market turmoil can also help shed light on diversification potential.
The core bond benchmark outpaced stocks and riskier bonds amid equity turmoil
![This chart shows the average cumulative excess returns of the Bloomberg U.S. Aggregate Index versus the S&P 500 Index and the Bloomberg U.S. High Yield 2% Issuer Capped Index. The first column shows a 17.8% excess return for the Aggregate Index relative to the S&P 500 Index. The second column shows a 7.6% excess return for the Aggregate Index relative to the High Yield Index.]](https://static.capitalgroup.com/content/dam/eacg/en/2023/q4/how-to-use-bonds-for-balance-as-fed-hikes-wind-down/chart-article-balanced-excess-returns-767x465.png)
Source: Morningstar. As of 31 October, 2023. Averages were calculated by using the cumulative returns of the Bloomberg US Aggregate Index versus the S&P 500 Index and the Bloomberg US High Yield 2% Issuer Capped Index during the eight equity market correction periods since 2010. Corrections are based on price declines of 10% or more (without dividends reinvested) in the unmanaged S&P 500 Index with at least 75% recovery. The cumulative returns are based on total returns. Ranges of returns for the equity corrections measured: Bloomberg U.S. Aggregate Index: –14.38% to 5.35%; S&P 500 Index: –10.1% to –33.79%; Bloomberg US High Yield 2% Issuer Capped Index: –20.76% to –1.45%. There have been periods when the Bloomberg US Aggregate Index has lagged the other indices, such as in rising equity markets. Past results are not predictive of results in future periods.
“When markets are volatile, we aim to use diversified levers in the construction of bond portfolios to provide attractive risk-adjusted income and diversification,” Purani says. “It enables us to pursue attractive returns while still offering diversification to equities in periods of market stress.”
A more constructive outlook
After a long slump, bonds may finally be poised to resume their role as equity diversifiers in investor portfolios. Inflation is trending down. Concerns over reinflation appear to be moderating. The policy rate may be near — if not at — the peak. These factors all bode well for the risk/return prospects for bonds.
Investors looking to add balance through fixed income should consider a fund’s exposure to high-quality holdings and duration. A proven long-term track record of strong relative returns in down equity markets is also essential, though past results are not predictive of results in future periods.
“Nobody can have certainty in today’s outlook,” Purani concludes. “But over the next 12 months, high-quality fixed income has the potential to provide attractive opportunities from both a yield and total return standpoint, supporting its traditional role as a ballast within diversified portfolios.”
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