Bonds Are Back as a Hedge After Failing Investors for Years

By Investor Empires On Aug 11, 2024

(Bloomberg) — Greg Abella, a New Jersey money manager, didn’t expect the deluge of calls he’s been getting from clients over the past week. “All of a sudden people are asking us, ‘Wow, do you think this is a good time for us to add bonds?’”

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This is vindication for Abella. He has been, as he puts it, “ringing the bell” for bonds—and asset diversification more broadly—for years. That recommendation was long out of favor. Until stocks started to slide this month. Demand for the safety of debt quickly surged, sending the yield on the 10-year Treasury note to its lowest level since mid-2023 early last week.

The rally has surprised many on Wall Street. The old relationship between stocks and bonds — where fixed income offsets losses when stocks fall — has been called into question in recent years. Especially in 2022, when that correlation broke down completely as bonds failed to offer any protection at all amid the stock rout. (In fact, U.S. government debt posted its worst losses ever that year.)

But while the selloff then was driven by rampant inflation and the Federal Reserve’s efforts to quell it by raising interest rates, the recent stock selloff has largely been driven by fears that the economy is sliding into recession. As a result, expectations for interest rate cuts have been growing rapidly, and bonds do very well in this environment.

“Finally the case for bonds is starting to come to light,” said Abela, whose firm, Investment Partners Asset Management, oversees about $250 million, including for wealthy Americans and nonprofits.

With the S&P 500 down about 6% in the first three days of August, the Treasury market gained about 2%. That has enabled investors who own 60% of their assets in stocks and 40% in bonds—a once-honored strategy for building a diversified, less volatile portfolio—to outperform investors who own only stocks.

Ultimately, bonds may erase much of their gains as stocks have stabilized over the past few days, but the broader point — that fixed income has acted as a hedge in a moment of market chaos — still holds.

“We’ve started buying government debt,” says George Curtis, portfolio manager at Twenty-Four Asset Management. In fact, Curtis began adding to Treasuries months ago—both because of the higher yields they now offer and because he, too, expected the old relationship between stocks and bonds to return as inflation eases. “They’re there as a hedge,” he says.

The opposite again

Another way to see it is that the traditional inverse relationship between the two asset classes—which prevailed mostly during the first two decades of this century—has returned, at least for the time being.

The monthly correlation between stocks and bonds last week hit its most negative level since the aftermath of last year’s regional banking crisis. A reading of 1 indicates assets are moving in unison, while a reading of -1 indicates they are moving in the opposite direction. A year ago, the correlation topped 0.8, the highest since 1996, suggesting bonds are virtually useless as a portfolio stabilizer.

The relationship was turned upside down when the Federal Reserve’s aggressive interest rate hikes in March 2022 sent both markets into a tailspin. The so-called 60/40 portfolio lost 17% that year, its worst performance since the global financial crisis in 2008.

Now the backdrop has shifted back in bonds’ favor, as inflation has come more under control and the focus has shifted to a potential recession in the United States at a time when yields are still well above their five-year average.

Next week holds plenty of risk for bond investors. July U.S. producer and consumer price reports are due, and any sign of a pickup in inflation could send yields higher again. They were already on the rise on Thursday after weekly jobless claims unexpectedly fell, easing signs of a weak labor market.

Despite all the excitement surrounding bonds today, there are still plenty of people like Bill Egan who are afraid to get back into the market.

Eigen, who manages the $10 billion JPMorgan Strategic Income Fund, has kept more than half that in cash—mostly in money-market funds that invest in cash-equivalent assets like Treasuries—over the past few years. At just over 5%, short-term Treasuries yield at least a full percentage point more than long-term bonds, and Eigen is not convinced that inflation is truly tame enough or the economy weak enough to merit the kind of easing the Fed might employ to change that dynamic.

“Rate cuts will be small and gradual. The biggest problem with bonds as a hedge is that we still have an inflationary environment,” he said.

What does Bloomberg News say?

“The yield curve tends to steepen sharply when a recession hits. The exceptionally brief inversion of the 2-year/10-year Treasury curve on August 5 may herald a downward trend that we expect to continue as the economy slows. At the same time, we believe the correlation between stocks and bonds may be returning to normal.”

—— Ira F. Jersey and Will Hoffman, Business Intelligence Strategy

But a growing number of investors, like Curtis, have seen inflation as a secondary concern. During the height of last week’s market volatility, bond investors sent a fleeting message that their concerns about growth were becoming acute. The yield on the 2-year note briefly fell below the 10-year yield for the first time in two years, suggesting that the market is bracing for a recession and a rapid rate cut.

“With inflation trending lower and risks more balanced or even tilted toward concerns about a more significant economic slowdown, we think bonds will show more of their defensive qualities,” said Daniel Ivascyn, chief investment officer at Pacific Investment Management.

What should you watch?

Economic data:
- August 12: New York Fed Annual Inflation Expectations; Monthly Budget Statement
- Aug. 13: NFIB Small Business Optimism; PPI
- August 14: MBA Mortgage Applications; CPI; Average Real Earnings
- August 15: Empire Manufacturing; Retail Sales; Philadelphia Fed Business Outlook; Jobless Claims; Import-Export Price Index; Industrial Production; Capacity Utilization; Manufacturing Production (SIC); Business Inventories; NAHB Housing Market Index; TIC Data
- Aug. 16: Housing starts; Building permits; New York Fed service business activity; University of Michigan sentiment
Federal Reserve Calendar:
- August 13: Atlanta Fed President Raphael Boucek
- August 15: St. Louis Fed President Alberto Musallam; Philadelphia Fed President Patrick Harker
- August 16: Chicago Fed President Austin Goolsbee
Auction Calendar:
- August 12: 13 and 26 week bills
- August 13: 42 days cash management invoices
- August 14: 17 weeks of bills
- August 15: 4 and 8 week bills

—With assistance from Michael Mackenzie.