The relationship between bonds and equities — one of the most closely followed correlation measures in financial markets — may be especially important to investors who employ a risk-parity approach.
In our analysis, as the bond-equity correlation turned strongly positive, the effect on risk-parity portfolios (allocated based on equal contribution of risk) was much greater than that on traditional 60% equity/40% bond portfolios (allocated based on asset type).
While bonds and equities tended to move together for a couple of decades, this relationship started to change fundamentally around 2002. Since then, they generally moved in opposite directions, providing a hedging benefit for multiasset-class portfolios.
Nevertheless, even in the pre-2002 era when this correlation was generally positive, in 42% of the months, bonds and equities moved in opposite directions. And vice versa: When the correlation was generally negative, bonds and equities moved in unison in 42% of the months. The correlation clearly shows an average trend; but even in periods of negative (positive) correlation, we still see a considerable number of months with positive (negative) bond-equity co-movement.
The explanation may lie in the underlying drivers of the bond-equity correlation. In times of low growth, when equities historically dropped and the central banks tended to lower interest rates, bonds and equities tended to move in opposite directions — a negative correlation that can be exacerbated by an equity-to-bond flight to quality in volatile market conditions. In times of high uncertainty about inflation, on the other hand, both bond and equity prices historically fell.
Financial markets, therefore, can behave differently from month to month, depending on what dominates the news. For example, in February 2018, the U.S. stock market fell 3.7%, while the 10-year U.S. Treasury yield went up by 15 basis points — displaying positive correlation. Also, in October 2018, stocks dropped 6.9%, while the yield went up 10 basis points (again, in positive correlation). In December 2018, however, stocks fell 9% and the yield went down by 32 basis points (negative correlation). This highlights the importance of assessing risk under different correlation regimes.
To assess the impact of the bond-equity correlation on portfolio risk, we estimate the bond-equity correlation based on the days when bonds moved opposite to equities and when they moved together, between January 2013 and January 2019. This allows us to test extreme assumptions for the bond-equity correlation, effectively changing it from nearly -70% to +60%. The full-period average correlation estimate was roughly -30%.
Next, we assess the risk of hypothetical traditional 60/40 and risk-parity portfolios for each of the three correlation estimates mentioned above during the same period. The 60/40 portfolio's risk was largely driven by equity risk, with bonds acting as a (small) cushion when the correlation was negative. Therefore, the difference in risk of a 60/40 portfolio between the two extreme correlation assumptions was marginal. The risk-parity portfolio, on the other hand, heavily overweighted bonds to obtain an equal risk contribution from both asset classes. For such portfolios, the total risk more than doubled when going from a strongly negative to a large positive correlation.
The above exhibit shows that 60/40 portfolios were much less sensitive to changing bond-equity correlation than a risk-parity portfolio was. But this does not mean there is no risk in 60/40 portfolios, which heavily overweight equities in terms of risk contribution. As a consequence, 60/40 portfolios were hit harder by increasing equity volatility, as the exhibit below shows.
We gauged this risk by looking at how the two portfolios would have performed using volatility assumptions based on data from two historical periods: a long-term volatility average over the 2013-2019 period and a more recent estimate that put more weight on the volatile year 2018. Annualized equity volatility over the shorter period was twice as high as volatility over the longer period (26% vs. 13%), whereas annualized bond volatility remained around 3.5% over both the long and short stretches. For that reason, the 60/40 portfolio's risk under the shorter-term scenario was twice as high as under the longer-term scenario. By contrast, the risk-parity portfolio was only 60% riskier under the shorter-term volatility scenario, relative to the portfolio's risk under the longer-term scenario.
Our analysis suggests that much depended on the asset-allocation approach. The risk-parity portfolio was more sensitive to changes in bond-equity correlation than the equity-heavy 60/40 portfolio was. However, the 60/40 portfolio was more vulnerable to rising equity volatility than the risk-parity portfolio.
Thomas Verbraken is executive director of MSCI Inc.'s risk management solutions research team, Budapest. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.