Bonds are still a hedge against stock market losses — this past month notwithstanding.
I’m referring to bonds’ failure to hedge the stock market’s 10% correction from the late-January high to the Feb. 8 low. During that decline, bond prices fell too. Their disappointing performance reinforces a belief that was already quite widespread: Low interest rates reduce, if not eliminate, bonds’ effectiveness as a stock market hedge.
That belief is unjustified, however. What happened over the last month, while rare, is not unprecedented. Since 1926, both the S&P 500 (.SPX) and intermediate-term U.S. Treasurys have fallen in 12.4% of the months — or once every eight months, on average. (See accompanying chart.) Investors are being unrealistic if they expect bonds — or any hedge, for that matter — to work all the time.
Furthermore, there is no historical evidence to suggest that bonds’ record as a hedge is appreciably different when interest rates are as low as they are now. Consider all those months since 1926 in which the yield on the 10-year Treasury was within 0.50 percentage points of where it stands currently. Both the S&P 500 and intermediate-term Treasurys fell in 14.2% of those months, which is not significantly different than the 12.4% frequency across all months.
In fact, bonds’ potential as a stock market hedge has become greater as the 10-year Treasury yield has risen to around the 3% level. Compared to its below-1.5% all-time low from the summer of 2016, the current level gives the Federal Reserve far more room to lower interest rates in order to jump-start the economy in the event of a recession. So even while interest rates’ recent rise has caused bonds to lose value, that rise simultaneously has increased their potential to be an effective hedge against future stock market declines.
This silver lining to interest-rate rises is also evident in the historical record: Situations like what we’ve seen over the past month are almost always temporary. When I focused on calendar years since 1926, instead of months, I found just two — 2.2% of the total — in which both the S&P 500 and intermediate-term Treasurys declined. So if stocks slide for the rest of 2018, chances are quite good that intermediate-term Treasurys will post a gain for the year.
The bottom line? While investors owning a diversified portfolio of stocks and bonds are surely disappointed that both asset classes fell in value this past month, that is no reason to give up on bonds as an effective hedge against future stock market declines. Ironically, in fact, bonds’ recent performance increases the likelihood they’ll be a useful hedge going forward.