Investor Note

Global sovereign investor insights 

The historic role of bonds as a cushion

In our advisory work for sovereigns, in particular central banks, we frequently see institutions which strongly rely on a substantial pool of fixed income assets to cushion losses which might occur in their growing equity tranche during periods of stress. And indeed it seems to be an established fact that investors will clamor for high-quality (i.e. government) bonds for protection during times of stress but shed those government bonds in search of higher yields and growth assets in risk-on environments.

This negative correlation between stocks and bonds has been persistent in the capital markets since the late 1990s, and many industry professionals investing today have never experienced it any other way. However, looking back further, the US market had a long period of a positive stock-bond correlation (Exhibit 1). In fact, since 1960, we can identify three regimes:

  • Jan 1960 to Dec 1965: low negative correlation (-0.12)
  • Jan 1966 to Jun 1998: persistent positive correlation (0.36)
  • July 1998 to Oct 2019: persistent negative correlation (-0.27)

Exhibit 1: Stock/bond correlation: Negative and positive regimes

Rolling 36-month values: S&P 500 with SBBI long government bonds

But Exhibit 1 is based on a rolling 36-month correlation. How strong is this relationship when we look at individual months? Or put more simply, how helpful are government bonds really as part of a diversified portfolio in market downturns?

Exhibit 2: Historic stock vs bond performance before and after June 1998

To answer that question, let's start by looking at some individual months, shown in two charts in Exhibit 2 above. The left-hand chart (July 1965 to June 1998) includes the dramatic crash of October 1987. The positive relationship between stocks and bonds is relatively strong (the coefficients are highly significant), but the R-squared is still quite low at 13%.

Exhibit 3: Stock vs. bond performance in worst-performing equity markets

15 Worst Equity Months

15 Worst Equity Months


S&P 500

Long Gov

 Oct 1987



 Oct 2008



 Aug 1998



 Sept 1974



 Nov 1973



 Sept 2002



 Feb 2009



 Mar 1980



 Feb 2001



 Aug 1990



 Dec 2018



 Sept 2008



 April 1970



 Oct 1978



 Aug 1974



15 Worst Equity 3-Months

15 Worst Equity 3-Months


S&P 500

Long Gov

Nov 2008



Nov 1987



Sept 1974



Oct 2008



Dec 1987



Dec 2008



June 1962



Oct 1987



June 1970



Feb 2009



Sept 2002



Aug 1974



July 2002



Sept 2001



Jan 2009



Exhibit 4: Equity vs. bond performance during six worst equity drawdowns



Cumulative Returns

Cumulative Returns



Long Bonds

Nov 2007 through Feb 2009



Aug 2002 through Sept 2002



Dec 1972 through Sept 1974



Sept 1987 through Nov 1987



Dec 1968 through June 1970



Jan 1962 through June 1962



In the second time period shown on the right (July 1998 to October 2019), the relationship is negative and includes the Global Financial Crisis of 2008-2009. Here, we again see significant relationships, but the R-squared is also quite low. Although long government bonds were quite helpful from November 2007 through February 2009—the S&P returned -50.9% while long bonds returned 16.0%—in some months, the relationship broke down, in particular October 2008 and January 2009.

What safety have long bonds offered on a monthly basis in the past?

Exhibit 3 lists the worst 15 equity months since the 1960s. From this perspective, the rationale for bonds as a cushion appears somewhat weak. In less than half the months, long US government bonds earned a positive return. However, we do note that if we take out October 2008 and roll it into the entire GFC, in five of the six worst periods bonds provided some protection. The one exception was the market disruption in November 1973, when markets were hit by the (inflationary) oil crisis. But if we broaden to rolling three-month periods, we see a higher proportion of safety offered by government bonds. However, these periods overlap, so we must be cautious about conclusions.

What safety have long bonds offered on a max drawdown basis in the past?

inally, let's look at the six worst drawdowns for equities using monthly data. As shown in Exhibit 4, in the two worst drawdowns, November 2007 through February 2009, and August 2002 through September 2002, bonds offered substantial projection, earning significant double-digit returns.

During two brief market drawdowns in 1987 and 1962, bonds offered small, but positive returns. In two equity drawdown periods, in 1972-1974 and 1968-1970, bonds declined, but not to the degree that equities did.

Exhibit 5: US stock-bond correlation & inflation

What causes different correlation regimes?

Although there are lots of disputes about what causes the stock-bond correlation, it appears that persistent inflation is a key factor. Exhibit 5, a scatter charter of rolling 36-month core inflation versus 36-month correlations is striking for its differences across regimes.

All in all, 2.5% core inflation seems to be the threshold of whether stocks and bonds cross over from negative/zero correlation to a positive correlation. With high inflation, stocks and bonds suffer and benefit together, as higher inflation hurts bonds as investors factor in higher interest rates, and equities suffer from pricing uncertainties and cost pressures. In low inflation environments, the discount rate for equities is more stable and it is earnings growth expectations that are at risk.

What does this mean for the next decade?

It turns out that on average, we can expect some benefit from bonds. However, they are in no way a perfect hedge and historically, there were enough cases where there was "no place to hide."

For the 2020s, with inflation expectations contained, we expect a slightly negative stock-bond correlation to continue. In fact, we don't expect interest rates to rise unless economic growth and inflation rises enough for central banks to feel comfortable in returning to 'normal' monetary policy. In a negative correlation regime, disciplined investors should expect some benefits in rebalancing between stocks and bonds.

However, the big tail event for investors may be that with the huge amounts of quantitative easing that have been applied across the globe, a move to a higher inflation regime eventually occurs. In this case, both stocks and bonds will be punished as the markets reprice expectations. As a consequence, we could expect a much steeper yield curve, with central banks simultaneously fighting higher inflation and sluggish growth (and rising government deficits), while investors demand an additional premium for the rising inflation risks.

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