Pleased to meet you Hope you guess my name But what’s puzzlin’ you Is the nature of my game —Sympathy for the Devil, by The Rolling Stones
In my experience, the most important function of bonds is their ability to mitigate portfolio losses during equity bear markets. However, bond portfolios can differ significantly with respect to their respective abilities to deliver this objective.
Economist and Nobel Prize recipient Milton Friedman was fond of stating, “There is no such thing as a free lunch,” which means that every choice has a cost.
Risk and reward increase together across fixed-income assets. The lowest-risk assets had the lowest returns and smallest drawdowns, according to data from FactSet Research Systems from 2000 to 2024.
For instance, T-Bills earned the lowest annualized return (1.8 per cent) and had almost no peak-to-trough losses (-0.4 per cent). Short-term Treasuries also showed modest annualized returns (2.4 per cent) and modest losses (-5.4 per cent).
Medium-term Treasuries and medium-term investment-grade corporate bonds had annualized returns of 4.1 and 4.7 per cent, respectively, but both saw peak-to-trough losses of about -23 per cent. Short-term investment-grade corporate bonds had lower risk (-9.7 per cent peak-to-trough loss) but similar annualized returns (four per cent).
Long-term Treasuries showed a relatively strong annualized return (4.5 per cent) but the largest peak-to-trough loss (-47.6 per cent). And higher-yielding credit offered the strongest returns but also larger losses: High-yield bonds and emerging-market sovereign bonds delivered the highest returns (4.9 per cent and 6.7 per cent annualized, respectively) and larger losses (-30.3 per cent and -26.8 per cent).
There is a clear relationship between the returns of the various segments of the bond market and the maximum losses that they have sustained over the past 25 years. If you want extra return, you can expect to suffer larger losses in bad times.
Higher returns are not only associated with larger losses but are also associated with higher correlations to equities, according to data from FactSet Research Systems from 2000 to 2024.
Treasuries showed low or negative correlation to S&P 500 equities, along with lower annualized returns. T-Bills delivered the lowest annualized return (1.8 per cent) with a low correlation to equities (-9.1 per cent). Short-term Treasuries had the most negative correlation to equities (-19.9 per cent) with lower annualized returns (2.4 per cent).
Corporate bonds were more equity-like. Short-term investment grade corporates had a correlation of 31.3 per cent to S&P 500 equities and four per cent annualized returns. Medium-term investment grade corporates had a 35.8 per cent correlation and 4.7 per cent annualized returns.
High-yield bonds had the highest correlation to the S&P 500 (69.7 per cent) and relatively high returns (4.9 per cent annualized). Emerging market sovereign bonds had a 55.1 per cent correlation to S&P 500 equities and a 6.7 per cent annualized return.
Bonds that offer higher returns have a greater tendency to move in tandem with stocks, thereby providing less ability to mitigate stock losses during bear markets. In contrast, lower return bonds have proved more effective in offsetting stock price declines during times of equity market turmoil.
Bonds can perform very differently in bear markets, offering anywhere from substantial to no protection from sharp declines in stock prices. What has worked in some bear markets has not in others.
As the accompanying chart shows, during the tech wreck of the early 2000s, all manner of bonds posted gains, with the exception of high yield bonds. Interestingly, medium-term investment grade corporate bonds rose more than Treasuries of similar duration, thereby providing a better offset to stock price declines. In addition, despite being one of the riskier segments of the bond market, emerging market sovereign bonds also posted significant gains.
Moving on to the global financial crisis, Treasuries of all durations provided some ballast within balanced portfolios, while other segments of the bond market failed to do so, with high yield and emerging market bonds suffering substantial losses.
Finally, in 2022 there was no corner of the bond market that offered a safe harbour. Any bond portfolio containing meaningful duration or credit risk was punished severely, with the higher risk corners of the bond market suffering the most severe losses.
Medium- to long-term Treasuries (the “heroes” of prior bear markets), medium-term investment grade corporate bonds, high yield bonds and emerging market bonds all experienced losses of more than 15 per cent to nearly 30 per cent. Simply stated, there was nowhere to hide, with only T-Bills (i.e. cash) emerging unscathed.
In bear markets, the corporate bond market has tended to become ominously illiquid. Those wishing to sell positions have either been unable to do so or had to do it at severely discounted prices.
Turning to the private debt market, which has experienced explosive growth over the past decade, liquidity issues are even more concerning. During times of heightened stress, private debt investors who succeed in liquidating their holdings at significant discounts should consider themselves fortunate, as there are many positions that become practically unsellable.
Importantly, illiquidity can deprive investors of meaningful ability to act and saddle them with considerable opportunity costs. After suffering massive declines during the global financial crisis, stocks bottomed out in mid-March of 2009. Over the course of the following several months, investors would have been well-served to take advantage of undervalued stocks and reallocate a larger portion of their portfolios to equities. However, to the extent that this would have necessitated liquidating corporate bond positions, losses in corporate bond positions would have left investors with less dry powder to allocate to equities.
Investors would be well-served not only to understand the degree to which their bond holdings are correlated to equities, but also to ensure that they offer sufficient liquidity to avoid large losses and permit them to take advantage of opportunities through market cycles.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
