Stock/Bond Correlations

The S&P 500 fell 5.26% in January while a common benchmark for bonds, the Bloomberg US Aggregate Bond Index, also declined. The iShares ETF that tracks this index was down 2.00% for the month. With rates still very low, does this imply that bonds are a poor diversifier for stocks?

Comparing returns for just one month may not provide enough evidence of diversification. Although, clearly, being down 2.00% is better than losing 5.26%. However, using the traditional 60/40 mix of stocks and bonds, the blended return was down 3.96% in January. Looking at the correlation of the two indices provides some clarity. The chart shows the S&P 500 and the correlation of the AGG and stocks.

The correlation is computed using 20 days of returns. The short time horizon highlights the variability of the correlation over time. Unfortunately, sometimes the correlations become positive when investors prefer the opposite. For instance, on January 5th, the S&P dropped 1.94% but the AGG also declined by 0.31%. This brings up the adage, correlation does not imply causation. But, in this case rising interest rates (falling bond prices) may have been a major cause of weak equity returns in January.

So, are bonds a poor diversifier for stocks? The short-term correlations say it depends. Interest rates have been trending down for 40 years, creating good positive returns for bonds while stocks have done well during the same period. With rates poised to continue increasing from here, bonds and stocks may struggle.