It’s a great time to be a bond investor. After the Fed’s recent path to higher rates, core bonds—investment-grade corporates, Treasuries, and municipal bonds—have not yielded this much in about a decade. This fact has put the income back into ‘fixed income’ investments. And now with the Fed starting to cut rates, bonds have the ability to provide some capital gains as well. All in all, core bonds are providing one heck of a total return proposition.
Bonds are also providing something else they haven’t been able to do in years.
They now provide a great source of volatility-dampening for a portfolio. Core bonds have once again gone back to being a way to reduce the volatility of equities and provide ballast against market shocks. For investors, it only heightens the appeal of having bonds in your portfolio.
Bouncy Stocks
If there is one thing equity investors don’t like, it has to be uncertainty. They can handle knowing a downturn is in the cards or that a firm is going belly-up. But what they don’t like is not knowing bad events are going to occur. And when there’s uncertainty about the economy, politics, or Fed policy, they get nervous.
That’s what’s going on right now.
Traders are facing a lot of unknowns these days. Inflation has started to drop, but it’s still higher than the Fed would like. The upcoming U.S. presidential election comes with plenty of unanswered questions on policy, taxes, and other issues. Economic data seems to point toward a growing economy. And yet, labor data has dipped, housing is still a mess, and manufacturing information seems to be contracting.
All of this doesn’t include any uncertainty growing across the globe.
Naturally, this has made investors jumpy. The CBOE VIX index—which looks at the cost of implied volatility inherent in options on the S&P 500—surged to 65 at the beginning of August. This is the highest level since the pandemic. And while the VIX has moved lower, it still has continued to swing violently and has once again resumed an upward trend.
Volatility has come back with a vengeance.
Core Bonds to the Rescue
For investors looking toward the equity markets, this volatility has been a hard pill to swallow. But there might be a way to navigate the volatility without resorting to a crazy strategy for hedging.
It turns out that core bonds can make for great volatility hedges and market risk hedges. Right now, investment-grade Treasuries and corporate bonds are doing just that.
Bonds and stocks ebb and flow into terms of their correlations to each other. They tend to be strongly correlated when inflation concerns outweigh economic ones. Moreover, their correlations increase when yields are low as well.
However, right now, uncertainty behind economic growth is driving the market’s bus. With that, bond-equity correlations have once again returned to negative territory. This chart from Goldman Sachs shows the trends in correlations with regard to economic worry and recession.
Source: Goldman Sachs
Moreover, bond yields are high, which helps drive correlations lower and into negative territory as well. According to Goldman, the Global Aggregate index—which tracks high-quality, global core fixed income bonds—was only yielding 1.25% back in January 2020. Today, it’s yielding more than 3.5%. 1
That’s important when it comes to volatility dampening. When yields are high, there are fewer reasons for investors to sell bonds, particularly when it comes to core bonds and the fact there’s a near guarantee you’ll get your principal back when the bond matures. You can sit back and simply collect your 4%+ and have safety of initial investment. There’s no reason to walk away.
The proof is in the pudding. Historically, negative correlations and high yields have worked well to make bonds a great defense against equity volatility. More recently, during the three-day period when stocks tumbled and the VIX hit its records, the Bloomberg U.S. Aggregate Index managed to gain 1.53%, not including any gained interest. Stocks? They managed to fall by over 6.9% during those three days.
The correlation and volatility dampening of bonds works.
The Case for Core Bonds
There are many reasons to own bonds in the current market. And now we can add being a hedge against stock market volatility and drawdowns back onto that list. Thanks to their high starting yields and shift in focus toward growth concerns, bonds are once again being a great hedge to equities.
And with that, core bonds should be bought. With their high current yields, investors can lock in volatility prevention in their portfolios with core fixed income assets today. Luckily, adding core bonds is a snap, both individually and through ETFs and funds.
Treasury bonds and investment-grade corporate bonds have a very liquid tertiary and secondary market. Moreover, most bond funds cover these bonds. Investors may want to look toward active management to score better yields and potential values. Either way, many types of core bonds are easy to purchase.
Core Bond ETFs
These ETFs were selected based on their low-cost exposure to core bonds, Treasuries, investment-grade corporate bonds, and mortgage-backed securities. They are sorted by their YTD total return, which ranges from -0.5% to 0.6%. They have expense ratios between 0.03% and 0.36% and assets under management between $55M and $314B. They are currently yielding between 3.6% and 4.8%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| VCRB | Vanguard Core Bond ETF | $110M | 0.6% | 3.8% | 0.10% | ETF | No |
| HCRB | Hartford Core Bond ETF | $223M | 0.3% | 4.3% | 0.29% | ETF | Yes |
| BND | Vanguard Total Bond Market Index Fund | $314B | 0.2% | 3.6% | 0.03% | ETF | No |
| FIGB | Fidelity Investment Grade Bond ETF | $55.4M | 0.1% | 4.2% | 0.36% | ETF | Yes |
| IUSB | iShares Core Total USD Bond Market ETF | $27.9B | 0% | 3.9% | 0.06% | ETF | No |
| AVIG | Avantis Core Fixed Income ETF | $691M | -0.3% | 4.8% | 0.15% | ETF | Yes |
| AGG | iShares Core U.S. Aggregate Bond ETF | $105B | -0.4% | 3.7% | 0.03% | ETF | No |
| SPAB | SPDR® Portfolio Aggregate Bond ETF | $7.65B | -0.4% | 3.9% | 0.03% | ETF | No |
| GBF | iShares Government/Credit Bond ETF | $330M | -0.5% | 3.8% | 0.20% | ETF | No |
Overall, bonds have started to act like ballast for a portfolio. High starting yields and the shift toward growth concern risks have made correlations negative. That’s a big win for investors looking to use bonds to defend against downside and rising price swings. The best part is that core bonds are easy to own through funds and individual bonds.
Bottom Line
Volatility is starting to rise as inflation concerns shift toward recession and slowdown potential. With that, bonds have once again started to act as defense against volatility and drawdowns. For investors, this just underscores the appeal of core bonds in a portfolio and why they are needed.
1 Goldman Sachs (September 2024). Navigating Volatility: The Strategic Advantage of Bonds