In doing some related research, I came across a Federal Reserve Bank of Atlanta research paper that I thought was worth sharing, especially in light of the tendency in recent years for many investors to stretch for yield.
Over the long term, the correlation of Treasury bonds (whether they are short-, intermediate- or long-term) to stocks is virtually zero. However, there is substantial variation in the correlation over time. Chris Stivers, Licheng Sun and Robert Connolly—authors of the 2002 study “Stock Implied Volatility, Stock Turnover, and the Stock-Bond Return Relation”—examined whether the variation in stock-bond return dynamics could be linked to non-return-based measures of stock market uncertainty, specifically the implied volatility from equity index options and stock turnover. The following is a summary of their findings:
· From a forward-looking perspective, the levels of volatility and turnover are both negatively associated with the future correlation between stock and bond returns. The probability of a negative correlation between daily stock and bond returns over the next month is several times greater following relatively high volatility and turnover.
· Bond returns tend to be relatively high (low) during days when volatility increases (decreases) and during days when stock turnover is unexpectedly high (low).
· Changes in expectations regarding inflation had little impact on the correlation of stock and bond returns. Instead, it’s shocks to uncertainty that drive the relationship.
· Similar outcomes were discovered when looking at international results, suggesting an important role for international crises, such as the Asian crisis of 1997 and the Russian crisis of 1998.
The Role Of Uncertainty
None of this should come as a surprise because economic theory suggests that shocks drive hedging behavior (flights to quality), causing the relationship between stock and bond returns to turn negative. Investors are averse to increases in uncertainty. Thus, an increase in uncertainty generates a high equity premium as it increases the marginal utility of consumption. In addition, an increase in uncertainty can lower interest rates because it increases the demand for safe bonds from investors concerned about their ability to consume.
The authors concluded: “Stock market uncertainty has cross-market pricing influences that play an important role in understanding joint stock-bond price formation. Further, our results imply that stock-bond diversification benefits increase with stock market uncertainty.” It’s important to note that the diversification benefit only applies to high-quality bonds. For example, in 2008 when the S&P 500 fell 37.0 percentage points, five-year Treasuries rose 13.0 percent and 20-year Treasuries rose 25.8 percent.
However, Vanguard’s High-Yield Bond Fund (VWEHX) fell 21.3 percent. Other high-yielding alternatives, such as utility stocks, REITs and MLPs, also produced large losses. And the riskier the credit, the larger the losses were.
For investors influenced by the Federal Reserve’s zero interest rate policy to chase yield and take on credit risk, this is an important reminder that credit risks have a nasty tendency to show up at exactly the wrong time—when stocks are hit by negative shocks and labor capital can be put at risk. In other words, credit risks don’t mix well with equity risks.
It’s also important to note that, historically, credit risk has not been well rewarded. The annual default premium, the difference between the return on long-term Treasuries and long-term corporate bonds, has only been about 0.2 percent.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.