Why Bonds Are Regaining Their Hedging Power in Today’s Market

Summary:

• The recent market selloff shows that bonds are once again acting as a hedge against a stock market crash.
• With yields currently at 3.7%, bonds provide better compensation for risk and a cushion against price declines compared to pre-COVID levels when yields were 2.5%.
• With real rates among the highest in 17 years, policymakers have ample room to implement rate cuts, which further supporting bond prices in case of a crisis
• If the anticipated crisis does not occur, markets will need to adjust their current expectations for interest rate cuts, causing Treasury yields to rise. To mitigate these risks, we prefer limiting duration exposure to bonds with maturities up to five years.

Traditionally, stocks and bonds have an inverse relationship, where bonds typically rise when stocks fall, providing a natural hedge. However, this correlation has weakened recently, reducing bonds' effectiveness as a diversification tool. The Federal Reserve's monetary policy played a significant role in this shift. Despite expectations for lower rates, the Fed raised rates through 2023 to control inflation. This stance led to simultaneous declines in both stocks and bonds, as rising rates hurt bond prices and negatively impacted stock valuations by increasing borrowing costs and reducing future cash flows. In 2024, the high correlation between stocks and bonds persisted due to ongoing economic uncertainties, including inflation concerns and the potential for a recession. Although the Fed paused rate hikes at 5.25%, earlier rate increases and economic conditions continued to influence both markets similarly, reducing the diversification benefits traditionally expected from a mixed stock and bond portfolio.

The main takeaway from the recent market selloff is that bonds are now acting as a hedge against the widespread equity selloff. Although returns won’t entirely offset severe market declines, this month's asset performance contrasts sharply with a year ago when both stocks and bonds fell simultaneously. Since the Federal Reserve meeting last Wednesday, the yield on 10-year US Treasuries has decreased by 36 basis points, while the yield on 2-year Treasuries has fallen by 53 basis points to 3.8%. This shift resulted in gains of 2.8% and 1%, respectively, within just a few days. In contrast, the S&P 500 and the Nasdaq have declined by 2.41% and 4%, respectively, since the FOMC meeting.

Why Bonds Are More Appealing Today Than Pre-COVID in Case of a Recession

Bonds can be a better hedge in the event of a stock market crash today, with yields at 3.7%, compared to pre-COVID levels when they were yielding 2.5%, for several reasons:

1. Higher Yield Provides Better Compensation for Risk:

• Increased Income: Bonds with higher yields provide greater interest income. A yield of 3.7% offers more substantial returns than a yield of 2.5%, providing investors with better compensation for the risk of holding bonds.
• Cushion Against Price Declines: The higher yield acts as a cushion against potential declines in bond prices. If interest rates rise or if there is market volatility, the higher yield helps mitigate the impact on the total return of the bond investment.
•  Mild Inflation Protection: While not as effective as inflation-linked bonds, a higher yield provides better protection against inflation compared to lower-yielding bonds.

2. Relative Attractiveness in an Overvalued Stock Market:

• Comparative Yield: In an environment where stock earnings become uncertain, bonds offering 3.7% might be more attractive than equities that might pay lower dividend yields in the future. This attractiveness can drive demand for these bonds, supporting their prices even in volatile markets.
• Flight to Safety: During a stock market crash, investors typically seek safe-haven assets. Higher-yielding bonds are more appealing because they combine safety with relatively better returns, increasing their demand and thus their hedging effectiveness.

3. Real Rates Remain Among the Highest in 17 Years, Enabling Policymakers to Implement Rate Cuts:

•  Economic Policy: Post-COVID economic policies, including monetary easing and fiscal stimulus, have contributed to a fast rise in inflation. Although inflation has yet to return to the central banks' 2% target, it is sensibly lower than a year ago, enabling policymakers to deliver interest rate cuts.

Where Bonds Can Falter: Risks of Long Duration in Times of Uncertainty

In today's market environment, where the possibility of a crisis is being priced in, policymakers remain calm and seem not to plan cutting interest rates as aggressively as bond future markets are anticipating today. This discrepancy between market expectations and actual policy stances poses significant risks for long-duration bonds. If the anticipated crisis does not materialize, markets will be forced to adjust their expectations and push back on rate cut projections. Such a shift would likely result in rising yields and falling prices for long-duration bonds, which are particularly sensitive to interest rate changes. Consequently, positions with high duration would face substantial pressure. Given these risks, we favor the front part of the yield curve, up to five years, as it provides a more stable investment option with less sensitivity to interest rate fluctuations, thus offering better protection in an uncertain economic landscape.

Conclusion

The recent market selloff shows that holding bonds is prudent during times of volatility and that the importance of a well-balanced portfolio cannot be overstated. While inflation remains above the Federal Reserve inflation target, bonds offer a compelling answer for investors concerned about a market crash, particularly due to their higher yields compared to the post-global financial crisis period. With yields at 3.7%, bonds provide better compensation for risk, making them more attractive than in previous years when the average yield for US Treasuries was 2.5%. Moreover, as real rates remain among the highest in 17 years, policymakers have more flexibility to implement rate cuts, which could further support bond prices.

In an overvalued stock market, bonds present a relatively attractive alternative. Their comparative yield makes them appealing in an environment where stock earnings are uncertain. Additionally, during market volatility, bonds serve as safe-haven assets, offering stability and better returns, which enhances their hedging effectiveness.

Yet, investors should be cautious about duration, as if a crisis doesn’t materialize, Treasury yields might rise posing a threat to position with long duration.