Institutional investors have traditionally used fixed income investments as a stabilizing ballast to mitigate the impact of public equity drawdowns on their portfolios.

• The behavior of bonds when equities fall can be quite variable and may not provide reliable stabilization.
• With Treasury bond yields now at historical lows, further strong price gains as a result of sharp drops in yields are unlikely.
• Equity stabilization based on a reliable volatility-based mechanism could provide portfolio protection where fixed income may fall short

Our research has shown that bonds have not provided reliable protection in equity drawdowns.

As we noted in a previous article, "Reliably improving the risk/return ratio,"  there have been long periods where equities and bonds were positively correlated, and thus traditional portfolio diversification did not reduce portfolio risk to the extent many investors expected.

This unreliability has been masked over the past 40 years due to the long secular decline in interest rates during that period. Some may still remember that the 10-year U.S. Treasury yield peaked at 15.8%1 in 1981 and has been falling (bumpily) ever since to its current 0.97% (December 4, 2020)2. That rate decline produced unexpectedly high bond returns - in the 20 years to September 30, 2020, for example, the ICE B of A ML 10+ Year U.S. Treasury Index returned 7.65% on average per annum3 - helping to offset  bonds’ periodically positive correlation with equities.*

There is about an equal chance that bonds will likely move with or against equities

Can bonds reliably hedge shorter-term equity downdrafts? To answer this question, our quantitative strategies team examined the distribution of returns of long-term Treasury futures for days when the S&P 500® Index went up and days when it went down. The result is that regardless of whether the S&P 500® went up or down in a day, there was about an equal likelihood that the long-term Treasury futures moved the same way or the opposite way to the equities (see Figure 1).

Bonds’ lackluster protection against equity selloffs is unlikely to be offset by outsized bond performance going forward.

With the yield on the Bloomberg Barclays U.S. Aggregate Bond Index at about 1.2%, and given the Index’s duration of about 6 years, even if the yield fell all the way to zero the Index would only gain approximately 7.2%. If bonds are held at the traditional 40% of an institution’s total portfolio, this would result in a return of 2.9% at the portfolio level - again, nowhere near enough to protect the portfolio against a simple bear market decline of 10%, much less against the 35% selloffs experienced in 2008 and March 2020. Any counterbalancing from bonds in future equity corrections is likely to be ineffective at best.

Fortunately, there is a reliable mechanism for stabilizing equity returns.

As we discussed in detail in “Reliably improving the risk/return ratio," the relationship between near-term equity volatility and equity returns is robust and dependable as a basis for volatility management (see Figure 2).

At Securian Asset Management, Inc., we are able to successfully exploit this reliable relationship - which holds across all major equity markets - to stabilize the volatility of equity portfolios. We believe allocations to this stabilization strategy must be permanent strategic allocations in order to achieve results, because no one knows when the next equity downdraft will occur. It’s important to always wear seatbelts when our cars are on the road!

Conclusion - publicly traded bonds aren’t reliable portfolio stabilizers ...

While “bonds offset stocks” is a popular narrative, the actual risk-free asset co-movement with equity isn’t nearly as strongly oppositional as institutional investors might expect or require. The poor portfolio hedging ability of bonds has been masked by the secular bull market in fixed income over the last 40 years - which is now over. Our belief is a permanent allocation to a volatility-based equity stabilization strategy provides a reliable counterbalance to equities for institutional investors needing that stability to meet their goals.

... Nor attractive income producers for now

Institutional investors could also benefit from replacing a portion of their publicly traded bond portfolio with private debt opportunities such as commercial mortgage loans and private investment grade debt. We believe these can offer more stability than publicly traded bonds, while providing significantly higher yields.

Combining volatility-based stabilization of the equity portfolio with private approaches to part of the debt portfolio can be a win-win combination for many institutional investors.

About Securian Asset Management, Inc.

As part of a financially stable mutual company, we focus on the long-term and seek to execute consistently for our clients. Our asset management business has been built with a risk and liability management focus, coming from our long, successful history investing for our parent company’s general account. We stay true to our purpose, our values and our St. Paul roots, while being innovative and nimble to help prepare our clients to meet their investment objectives from a position of strength.