The use of long-duration fixed income as a hedge of equity market risk has become widely accepted and adopted by many allocators. However, can bonds provide the downside protection we need in the next downturn? We are not so sure.
As experienced investors and asset allocators, we have encountered numerous assumptions, hypotheses and theories about the financial markets. Once enough people adopt a set of ideas, these ideas often become "conventional wisdom," part of our industry vernacular and rarely challenged. Few go back and analyze the facts and assumptions supporting this conventional wisdom and whether they are likely to hold in the future. So, we decided to ask: How did the idea of using long-duration fixed income as a hedge of equity downside come about and is it a good idea for the future?
In the last two bear markets, holdings in long-duration fixed income would have been excellent sources of excess returns to offset equity market losses. When global equities lost 46% in the tech bust from March 2000 to March 2003, the seven- to 10-year U.S. Treasury index gained 18%. In a similar fashion, the 55% drop in equities during the global financial crisis, from October 2007 to February 2009, was accompanied by a 16% gain in the seven- to 10-year index. Based on these events, the idea has taken hold that fixed income is a reasonably good hedge of equity downside risk.
After the financial crisis, we also saw the dramatic rise of risk-parity strategies. A fundamental aspect of the risk-parity approach is that a larger portion of the risk budget is allocated to duration, in part as an offset to equity risk. Major allocators are now boosting fixed-income duration as a risk management tool, both by increasing risk-parity holdings and by raising long-duration allocations.
What might come as a surprise is that if we look further back in time, this significantly negative correlation between stock returns and bond returns was not always the case. In fact, it was historically unusual. The chart below shows the trailing 10-year stock/bond correlation for the U.S. The last 10 years have the lowest correlation of the past century. The average correlation is positive, with long stretches at 0.3 or higher.