After Failing Investors for Years, Bonds Are Back as a Hedge

Gregg Abella, a money manager based in New Jersey, was taken aback by the surge of phone calls he received from clients this past week. "Suddenly, people are asking us, 'Is now a good time to add bonds to our portfolios?'" he remarked.

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For Abella, this influx of interest in bonds feels like a form of validation. He has been a vocal advocate for bonds and broader asset diversification for years, a strategy that had been largely out of favor until recently. However, with the stock market's recent downturn, the demand for the relative safety of bonds has surged, driving 10-year Treasury yields to their lowest levels since mid-2023 at one point early last week.

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This rally in bonds has caught many on Wall Street by surprise. The traditional relationship between stocks and bonds, where bonds serve as a safe haven when stocks decline, had been called into question in recent years. This was particularly evident in 2022 when that correlation broke down completely as bonds failed to provide any protection during the stock market's slide. In fact, U.S. government debt suffered its worst losses on record that year.

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The previous selloff was triggered by a sudden spike in inflation and the Federal Reserve's aggressive response of rapidly raising interest rates to combat it. In contrast, the recent stock market slump has been driven largely by fears of an impending recession. As a result, expectations for rate cuts have risen quickly, creating a favorable environment for bonds.

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"Finally, the case for bonds is becoming clear," said Abella, whose firm, Investment Partners Asset Management, manages around $250 million for wealthy individuals and nonprofits.

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As the S&P 500 Index lost roughly 6% during the first three trading days of August, the Treasury market gained nearly 2%. This allowed investors who had 60% of their assets in stocks and 40% in bonds—a traditional strategy for building a diversified portfolio with reduced volatility—to outperform those who were solely invested in equities.

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Although bonds eventually gave up much of their gains as stocks stabilized later in the week, the key takeaway remains: fixed income provided effective protection during a moment of market turmoil.

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George Curtis, a portfolio manager at TwentyFour Asset Management, shared a similar sentiment. Curtis began adding Treasury bonds to his portfolio months ago, attracted by their higher yields and the expectation that the old stock-bond relationship would reemerge as inflation subsided. "It's there as a hedge," he said.

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The Return of the Inverse Relationship

Another indicator that the traditional inverse relationship between stocks and bonds is back, at least for now, is the one-month correlation between the two asset classes. Last week, this correlation reached its most negative level since the aftermath of last year's regional banking crisis. A correlation reading of 1 means the assets move in tandem, while a reading of minus 1 suggests they move in opposite directions. A year ago, the correlation exceeded 0.8, the highest level since 1996, indicating that bonds were practically useless as a portfolio hedge.

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This relationship was upended when the Fed's aggressive rate hikes, beginning in March 2022, caused both markets to plummet. The so-called 60/40 portfolio strategy lost 17% that year, marking its worst performance since the global financial crisis of 2008.

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However, the landscape has now shifted back in favor of bonds. With inflation more under control and attention shifting to the possibility of a U.S. recession, bonds are once again gaining favor, especially as yields remain well above their five-year average.

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The upcoming week poses some risks for bond enthusiasts. July reports on U.S. producer and consumer prices are due, and any sign of a resurgence in inflation could push yields back up. Indeed, yields began ticking higher last Thursday after a surprising drop in weekly jobless claims, a data point that has gained renewed attention as recession concerns grow.

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Despite the renewed interest in bonds, some investors remain cautious. Bill Eigen, who manages the $10 billion JPMorgan Strategic Income Opportunities Fund, has kept more than half of it in cash, mostly in money-market funds that invest in cash-equivalent assets like Treasury bills. With short-term T-bills yielding just over 5%, at least a full percentage point more than long-term bonds, Eigen is not convinced that inflation is sufficiently tamed or that the economy is weak enough to justify the kind of Fed easing that would benefit bonds.

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"The rate cuts are going to be small and incremental," Eigen said. "The biggest challenge for bonds as a hedge is that we still have an inflationary environment."

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While some, like Eigen, remain skeptical, a growing number of investors are more concerned about economic growth than inflation. During last week's market volatility, bond investors sent a strong signal that their fears about an economic downturn were intensifying. For the first time in two years, yields on two-year notes briefly traded below those on 10-year bonds, indicating that the market was bracing for a recession and rapid rate cuts.

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"With inflation trending lower and risks more balanced or even tilted towards a more significant economic slowdown, we believe bonds will exhibit more of their defensive characteristics," said Daniel Ivascyn, chief investment officer at Pacific Investment Management Co.

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