Resilience of Bonds in a Shifting Market

By Jamie McGeever
ORLANDO, Florida (Reuters)

The past month in markets has been marked by significant events: a record surge in U.S. stock market volatility, near-confirmation from the Federal Reserve about upcoming U.S. interest rate cuts, and the largest one-day market cap crash in history for a listed company.

Despite these fluctuations, the resilience of bonds has remained a constant, reaffirming their role as a classic hedge in a diversified portfolio. This may indicate a shift in the economic landscape, with investors moving away from equities—currently near record highs and deemed historically expensive—towards fixed income.

With a traditional ’60-40′ investment portfolio, bonds will need to shoulder a significant load if this trend continues.

Bonds’ strong performance did not begin recently; U.S. Treasury yields have generally fallen since April. Asset managers have built long Treasury futures positions significantly this year. According to Bank of America, global bond funds have garnered $425 billion in inflows in 2023, approximately $40 billion more than global equity funds. Inflows into U.S. mutual fund bonds this year are around $315 billion, nearly four times those for equities.

This movement towards bonds indicates that investors are preparing for a rise in fixed-income returns that has yet to materialize. The ICE BofA Treasury index has risen just 3% this year, while the S&P 500 has increased over 15%, despite recent volatility.

Return to ‘Normal’?

The traditional balanced portfolio is based on the premise that the 60% equity allocation drives most returns, while the 40% bond allocation offers stability during market turmoil. This theory hinges on having a negative correlation between equities and bonds during downturns. Recently, however, the correlation between the S&P 500 and Treasuries was notably positive, as concerns around high interest rates overshadowed growth.

That correlation seems to be changing. Strategists at Truist Advisory Services observed that core bond returns were positive during a recent 8.5% drawdown of the S&P 500. The last occurrence of stocks falling over 5% while bonds gained was over four years ago.

While one month does not establish a trend, markets may be at an inflection point. The concerns affecting the equity market are shifting from persistent high borrowing costs to fears of a ‘hard landing’ for the economy—now primarily worried about growth rather than inflation.

The market reaction to minor negative economic data highlights this shift. For instance, recent data showed U.S. manufacturing activity contracted in August—leading to a notable retreat from stocks in favor of bonds. The S&P 500 experienced its largest single-day drop following an ISM release since October 2022.

Should the anticipated soft landing fail and the economy plunge into recession, historical patterns suggest that equities will drop while Treasuries will rise. Conversely, if growth slows without a recession, both equities and bonds may appreciate. In either scenario, bonds appear to be the safer investment.

Ultimately, if the traditional 60-40 portfolio underperforms in the coming months, it likely will not be due to bonds.

(The opinions expressed here are those of the author, a columnist for Reuters.)