Now's the time for investors to add more bonds to their portfolios. Here's why.

By Joseph Adinolfi

History shows mixed portfolios outperform when the stock-bond correlation is falling

A significant shift in the trading relationship between stocks and bonds has gotten under way. Similar situations in the past have boosted returns for investors who owned both, according to an analysis from Verdad.

Lionel Smoler-Schatz, a Verdad analyst, dug into how model portfolios with different mixes of assets performed when the correlation between stock and bond performance was in flux.

He found that when the correlation between stocks and bonds was falling, portfolios with substantial allocations to both tended to outperform. Specifically, during a falling scenario, returns for a portfolio featuring 60% stocks and 40% bonds surpassed portfolios with 100% exposure to stocks on both an absolute and risk-adjusted basis.

Note: returns were presented on an annualized basis, but the results were extrapolated from rolling one-month performance.

The correlation between stocks and bonds has recently moved back toward negative territory for the first time in about three years. It's one reason investors who abandoned bonds during a harrowing bear market might want to consider getting back in now.

Typically, the relationship between stocks and bonds has fallen when the Federal Reserve has been cutting interest rates. In the past, when rates were coming down, bond investors have benefited for two main reasons: bond prices tended to rise as interest rates fell, and gains in bond prices often offset losses for stocks.

"The strength of the 60/40 portfolio in these periods lies in its ability to reduce equity volatility and benefit from bond price appreciation during equity downturns," Smoler-Schatz wrote, in a report shared with MarketWatch.

He also mapped out the correlation between a portfolio of global stocks and the price of the 10-year Treasury note in the chart below, which showcased the dramatic drop seen over the past two months.

Most investors first noticed the change when bonds helped to offset losses from a punishing stock-market rout in early-August selloff, as MarketWatch reported at the time. Bonds again served as a buffer in early September during another bout of volatility in the equity market.

See: A wild week for stocks has bonds playing defense again for first time in years

These episodes marked the return of a once-standard trading relationship between the two that has been largely absent for nearly three years. The Federal Reserve's aggressive interest-rate hikes, prescribed to combat the worst bout of inflation in four decades, caused bonds and stocks to sell off in tandem in 2022, which resulted in the worst calendar-year return for a balanced portfolio in decades, Wall Street analysts said.

To be sure, there have been plenty of periods in the past where the relationship between stocks and bonds has turned upside down, most recently in the 1980s and 1990s, according to data shared with MarketWatch by Morningstar earlier this year.

However, the correlation had mostly resided in negative territory beginning in the early 2000s. Low inflation, combined with stimulus measures adopted by the Fed following the 2008 financial crisis, helped keep it there for years, until the post-COVID inflation reared its head.

See: Stocks and bonds haven't been this in sync in decades: why both still deserve space in your portfolio

U.S. stocks in the first nine months of 2024 were on the cusp of their best such stretch since the late 1990s, with the S&P 500 SPX up 20.3% year-to-date as of midday on Monday. The index stood at 5,738 in recent trade, and was little-changed on the day, according to FactSet data.

But many on Wall Street have doubts about whether stocks will be able to maintain their rapid pace of gains, given that the S&P 500 has already risen more than 60% since its October 2022 bear-market low.

An ETF that tracks the performance of longer-term Treasury bonds, meanwhile, was down slightly year-to-date. But the iShares 20+ Year Treasury Bond ETF TLT has gained more than 11% over the past 12 months, and 1.8% during September, data showed. Verdad's analysis would suggest that better returns lie ahead, even as Treasury yields initially rose after the Fed cut interest rates.

The 10-year yield BX:TMUBMUSD10Y was at 3.76% on Monday, up from a one-year low of 3.622% in mid-September, right before the Fed cut rates for the first time in four years.

-Joseph Adinolfi

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09-30-24 1303ET

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