Are Bonds a Poor Hedge for Stocks?
What has happened to the negative correlation usually observed between stocks and bonds? The primary suspect is inflation.
Bonds have generally been seen as a great hedge for stocks in an investment portfolio. In most cases, investors expect the value of bonds to increase when the value of stocks decreases. This relationship usually holds as when uncertainty increases, investors are expected to re-evaluate their portfolios and allocate to safer asset classes such as fixed income.
Many investors utilize fixed income to reduce the volatility of their investment portfolios, in addition to using the coupons from bonds to generate predictable and consistent income.
So far this year, both stocks and bonds (treasuries) have performed poorly. What has happened to the negative correlation usually observed between stocks and bonds? The primary suspect is inflation.
Inflation History
Inflation has been in check for the last few decades in the Canadian economy. In fact, until 2021, annual inflation in Canada had not been above 3.0% since 1991. This is 30 years of consistent inflation anchored around the central bank’s target of 2.0%. The latest Consumer Price Index released in April 2022 showed consumer prices rise to 6.8% y/y. Excluding gasoline, the Consumer Price Index rose 5.8% y/y in April, which is still far above the Bank of Canada’s targeted inflation rate.
Canadian Equity and Fixed Income Performance
As mentioned, when equities underperform, it is usually expected that fixed income will outperform. However, year-to-date in 2022, both asset classes have performed poorly. XBB (iShares Canadian Universe Bond Index ETF) has drawn down 10.0% YTD, while XIU (iShares S&P/TSX 60 Index ETF) has lost 3.6% of its value YTD.
Canadian equities have been slightly helped because its largest constituents operate in the Financials, Energy, and Materials sectors. These sectors broadly perform better when inflation is high, and interest rates rise.
Are Bonds’ Ability to Act as a Hedge for Equites Eroding?
The simple answer is no. This market environment has been brought upon by COVID-19 and its impacts on supply chains which have contributed to high inflation. Persistent inflation leads to fears of an overheating economy, or worse, stagflation. Central banks have responded to these fears by signalling an increase in the targeted interbank lending rate and actually increasing the targeted interbank lending rate. This re-prices risk for all financial assets.
From Fixed Income 101 class, it is known that when rates rise, bond prices fall. Furthermore, the discount rate for equities increases as well, leading to a contraction in valuation multiples. Central bank actions and the fear of persistently high inflation have led to a broad-based sell-off in both the fixed income market and the stock market.
The sell-off in bonds and stocks will not persist forever, though, and bonds are becoming more attractive as an asset class as yields continue to rise. Central banks have a mandate to keep inflation in check. In the past 30 years in Canada, the Bank of Canada has not had to worry much about inflation, leading to a persistent decline in yields. As inflation normalizes, the relationship between stocks and bonds may return to its normal negative correlation.
Where to Position if Inflation Persists?
While high inflation rates may not last forever, they may be around for a while. Where are some areas that may act as equity hedges during this time of turmoil?
Money Market Securities
Cash, no, not physical cash under the pillow, but money market securities with very short maturities may act as a good hedge to equities during this time of rising short-term rates.
Commodities
Commodities are an asset class that has historically benefitted from high inflation. As they are related to raw materials, the price increase in these raw materials directly benefits this asset class.
- XMA (iShares S&P/TSX Capped Materials Index ETF)
- VAW (Vanguard Materials ETF)
- XEG (iShares S&P/TSX Capped Energy Index ETF)
- VDE (Vanguard Energy ETF)
Real Estate
Real estate is seen as a hedge for inflation since the value of real estate appreciates, and rental income can also increase with inflation.
Data for this article is as of May 25th, 2022.
Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.
