With bonds quietly coming through with a strong year, we review their notable change in correlations to equities and their recovery from disaster in 2022.
What if we told you there’s a group besides metals and equities having its third-best year since 2011, nearing all-time highs for the first time in over five years, and posting one of its strongest two-year runs this century? If you guessed fixed income, congrats on reading the title.
Bonds aren’t the flashiest securities in the world, but the performance of the asset class has flown under the radar this year. The iShares US Core Bond ETF (AGG) has delivered 6.5% on a total return basis including dividends over the past year, peaking at 7% in late October. Aside from late 2024 and 2019–2020, that’s the highest one-year return for AGG in the past decade. Meanwhile, the 6.6% YTD return for AGG would be its third best year since 2011. Things look even better over the last two years, with the AGG gaining 15% on a total return basis, which is among the best two-year spans in the 21st century. With all these positive developments, what happened to sour bond investors despite such a strong two years?
Recent performance has been overshadowed by the disastrous period from late 2020 to 2022 in which the market was caught completely off guard. Rates plunged to record lows in 2020, then surged at a historic pace through 2022, thrashing the bond market in its wake. With bonds prices moving inversely to rates, the asset class has been uncharacteristically volatile, shattering assumptions about fixed income’s diversification and capital-preservation benefits.
One of the biggest benefits of bonds is their potentially uncorrelated returns with equities, reducing portfolio volatility. The asset class saw solid performance during the Dotcom Bubble and Great Recession even as stocks plummeted, but the 2022 bear market saw bonds decline alongside stocks as inflation roared. As a result, the correlation between equities and bonds hit some of their highest levels ever. The one-year and three-year correlations between the S&P 500 (SPX) and AGG hit a high among the highest levels on record around 0.6 last July. Those correlations have since fallen significantly, with the three-year correlation at 0.32 while the one-year correlation sits at just 0.11. A lower correlation to equities would mean fixed income offers greater diversification benefits, as the group should theoretically see less downside if equities were to fall.
Another benefit of fixed income is its ability to limit downside relative to equities, as the asset class normally sees less downside in general. Prior to 2021, AGG had only declined in three of its 32-year history, meaning it was positive in over 90% of years. Meanwhile, bonds made money over every single five-year period… until it finally didn’t in the 2020s, with AGG down 2% the last five years including dividends.
Those counting on the safety of bonds were left hanging in 2022, with bonds declining by 15%, which was 11.2% worse than the next closest calendar year. Meanwhile, the current drawdown (peak-to-trough decline) for AGG hit a maximum of 18.4% in June of 2022, which is also the worst ever by ~6%.
The decline in bonds has been notable not only for the severity of its decline but also for the length of recovery. AGG has been off its all-time high for over 63 months and counting. Prior to 2020, the longest drawdown was only 17 months, meaning our current one is the longest drawdown by 46 months. That said, the worst modern period ever for bonds might be coming to an end. AGG is within 3% of setting new all-time highs on a total return basis, meaning the bond drought could come to an end in the coming months.
Bonds breaking out to new highs while their correlation to equities decreases would be positive for the asset class, but it’s important not to lose sight of the opportunity cost associated with the group. While the bond market has yet to end its drawdown, the S&P 500 set new highs at the beginning of last year and is up 39% since then. Equities continue to hold the most long-term strength among asset classes while fixed income continues to rank at the very bottom of DALI. Additionally, fixed income is still far off from its all-time highs on an inflation adjusted basis, as the CPI is up 25% from AGG’s peak in August of 2020. The worst modern era for fixed income may soon come to a close, but that doesn’t mean fixed income is suddenly the strongest asset class, as the group has significant ground to cover after years as one of the market’s biggest laggards.
