The equity-bond correlation is not as ugly as it looks

The equity-bond correlation is not as ugly as it looks

Equities 4 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  The low interest rates have caused many to say the 60/40 portfolio is dead. Maybe it is conceptually, but it does not mean that bonds should not play a role in portfolios. The correlation between equities and bonds have historically been positive but in recent capital market history it has been negative making asset allocation much easier. With the recent rise in correlation between equities and bonds one could wrongfully think that trouble is coming. However, if one looks at the 10% worst days in equities and calculates the correlation to bonds over a sliding 1-year window, then one realises that bonds still offer the much needed protection in most cases when equities experience large declines.


These days many commentators are declaring the death of the “60-40 portfolio”, which is 60% in equities and 40% in bonds, that has been the core portfolio concept in retirement strategies. With plunging interest rates the future returns are likely to be low but going out on the risk curve is not a free lunch as valuations on growth pockets have become quite stretched. Whether or not the 60/40 portfolio is dead or not is semantics and not the point of this note. Many commentators have recently talked about the fact that the correlation between equities and bonds has historically been more positive than the recent decades with more negative correlation making asset allocation strategies look easy. Recently the correlation is turning positive again and many have argued that the link is inflation, which is not unreasonable, but is this positive correlation a bad thing?

The more interesting question is whether bonds still play a role in portfolios. Yes, they do. The chart below shows the real strength of bonds in the portfolio. The chart shows the running correlation between global equities and global government bonds on the 10% worst trading days in global equities in 1-year sliding window. As we can see, the overall tail-risk correlation is slightly negative over the entire period since 2002 and is currently slightly positive but not alarmingly high. That is not to say that we could not get there on an inflation shock, but the tail-risk correlation shows you that bonds, despite their low expected return, are still the best way to offset risk for ordinary long-term investors. Also note that the worst tail-risk correlation happened during Bernanke’s taper tantrum in 2013, followed by the Greenspan surprise interest rate hike in 2004 and the EM/oil selloff in 2015.

Source: Bloomberg and Saxo Group

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)

Saxo Markets
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Support Centre
For existing clients, please click here to request support via the Support Centre.

Have a question about our products, platforms or services? Visit the Support Centre to find answers for our most frequently asked questions. If you are still unable to locate an answer to your question, you will also find contact details for your local Saxo office to speak with a representative.

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo Markets is a registered Trading Name of Saxo Capital Markets UK Ltd (‘SCML’). SCML is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo Markets assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.