In the last post I discussed the role of bonds in playing portfolio defense. I used 10 Year U.S. Treasuries as a proxy for bonds due to historical data availability. In reality, however, most investors use different kinds of bonds in their portfolios. Another issue is that the calendar year returns often mask significant intra-year moves. So if our goal is to use bonds as shock absorbers, it’s useful to look at the exact time periods when such help is needed. The purpose of this post is to determine which types of bonds do best in stock market downturns.

To illustrate, let’s consider the latest significant pullback in the stock market – a 20% drop from September to December 2018 (Exhibit 1). As you can see some bonds held up just fine, while others declined alongside the market. Then (naturally) on the fast & furious rebound from the bottom on December 24 to the latest market top on July 26, these same riskier bonds like High Yield and Convertibles have bounced much stronger than the safer bonds (Exhibit 2). This is just one example of a downturn, but this relationship holds when looking at other ones. So with that in mind let’s consider what we want from our bonds. If we want offense, i.e. something that will go up the most in good times, we might as well stick with the best offensive instrument – stocks themselves. If, however, we want to dampen the volatility in bad times, buying high quality bonds is the way to go.

Exhibit 1 – Performance of stocks and various bonds in the 2018 downturn

Exhibit 2 – Performance of stocks and various bonds in the 2019 recovery

Now that we laid the groundwork, let’s review a number of turbulent market periods. I went back to back to 1998 and identified significant stock selloffs of over 10% (Exhibit 3). Some of them were painful and protracted bear markets, while others were just quick pullbacks on the way to higher prices.  The way to read the table is to look at each pullback and how various bonds did during it. For the 2018 one you can see that stocks dropped 20.2% while the Total Bond Market (The Agg) went up by 1.5%. Various flavors of High Quality bonds also went up until we get to Investment Grade Corporates which declined by 1%. Then we have Junk & Hybrids in various degrees of negativity. The relationships are quite stable. Total Bond was positive in all 7 of our pullback periods with the average return of 7.1% (not annualized).  Correlation with stock returns in the periods was a negative 65% (good for zig & zag purposes). U.S. Treasury Bonds of longer maturity offer the best defensive characteristics on average. High yield, convertible and Preferreds are NOT good defense for stock declines. They were all negative in all periods and exhibit much higher correlation with stocks than bonds.

Side note: Gold has actually worked great as a hedge with very negative correlation with stocks and relatively weak relationship with bonds. It went up every time the stocks pulled back and had an average gain of 8.5%. I will do a separate post on gold and why I’m not a fan despite its diversification potential.

Exhibit 3 – Performance of various instruments during stock market selloffs

Notes and Takeaways

• The basic relationship is that higher quality (especially Treasuries) and longer maturity bonds are better at defense.
• I also analyzed many other investments for their defensive properties. I didn’t want to clog things up with copious analysis tables here, but I would be happy to share them if anyone is interested. Moreover, there are some data history issues as many index funds weren’t around in earlier periods.
• I tested all sorts of stocks (small, midcap, NASDAQ, foreign of many varieties) and they were all very highly correlated with Total Stock Market. Same goes for equity sectors – most are lousy diversifiers for the market. Real Estate, Utilities & Consumer Staples do behave a little differently but still don’t offer consistent and reliable drop protection.
• I also tested all sorts of other bond flavors (leveraged loans, short/intermediate/long corporates and treasuries, foreign bonds, MBS, TIPS, money market, etc). The basic relationship on quality and maturity holds in most cases.
• So why would you just not load up on Long Treasuries and call it a day? (see last column in Exhibit 3). Well, that’s where the massive duration and interest rate risk comes in, so these bonds are not for the faint of heart! See Ben Carlson’s take on it here and here.
• In the next post I will look at what happens to all these instruments when the rates go up.