The Importance Of Quality When Diversifying A Stock Portfolio With Bonds

by: Gene Balas, CFA


Stocks and bonds can move in tandem at some times, particularly when both respond to an unexpected increase in interest rates, for example.

The market’s volatility gauge, the VIX, tends to correlate with investment grade bond credit spreads, meaning that there is some relationship of risk perception in both stocks and corporate bonds.

As a result of perceptions of shared risks between even AA-rated corporate bonds and stocks, investment grade corporate bonds can underperform Treasuries in periods of risk aversion.

Why does this matter now? There may be some signs of risk in the equity markets, including that pertaining to sentiment, valuation and technicals.

The bottom line: Treasury bonds are assumed to be the ultimate risk-free security (other than interest rate risk), arguably making them better at diversifying stocks than corporate bonds.

When investors diversify their equity portfolio by adding bonds, not all bonds are created equal in this regard. Certainly, corporate bonds, including both high yield and investment grade, do pay a yield premium over Treasuries. If you're after income, that might be a worthwhile consideration, but if you're focused on providing a means of diversification to stocks, you might want to emphasize quality. And that means Treasuries, as even AA-rated corporate bonds can impede levels of diversification vis-à-vis bonds that carry no credit risk, as we will see.

Stocks and bonds can move in tandem at some times

Before we get into a discussion on what types of fixed income, if any, one might use in a diversified portfolio, we would be remiss not to mention one critical area where bonds and stocks might move in tandem. For example, investors already expect the Fed to move two or three times this year, so that much may already be priced into the markets. However, if the Fed indicates it is more worried than investors now think about things ranging from inflation to asset bubbles, and/or that it wants to move faster than the markets expect, that can upset both the bond and stock markets simultaneously.

The market's volatility gauge tends to correlate with investment grade bond credit spreads

With that caveat out of the way, let's look at how components of even investment grade corporate bond prices can move in tandem with stocks. First, let's look at how the popular "fear gauge" investors often follow, the VIX - the implied volatility of the stock market obtained from options prices - correlates with yields of bonds rated AA by Standard & Poor's. An "AA" rating is solidly investment grade.

We'll focus on the difference of AA-rated corporate bond yields and that of Treasuries of the same maturity, known as the credit spread. When investors are fearful, both the VIX and credit spreads rise, as seen in the nearby graph, and when investors aren't so worried, these measures fall.

Even investment grade corporate bonds can underperform Treasuries in periods of risk aversion

Let's think about this a bit differently. As you probably know, when yields rise, bond prices fall. When credit spreads rise, corporate bonds tend to underperform Treasuries, as the yield for corporate bonds is either rising more or falling less than yields on bonds that have no credit risk.

Now, what happens to credit spreads when equity markets tumble? We can look at the neatly inverse relationship between credit spreads on AA-rated corporate bonds - again, these are solidly investment grade - and the S&P 500 in the nearby graph. What we see in the nearby graph is that credit spreads often rise when the stock market falls. That makes intuitive sense, as what constitutes a risk for the stock of a company also may be a risk for bonds issued by the same company, multiplied, of course, across the entire universe of tradeable securities.

There may be some signs of risk in the equity markets

Why does this matter now? Consider a different item, that of whether risks are present in the equity markets. It is very difficult to predict market returns, especially over shorter time periods. But what we can do is at least take a look at what some signals of risk tell us. Many investors tend to be contrarian for a reason: When others are bullish, all the good news might already be priced into the market. So, when sentiment is high, that, to some investors at least, is a signal that markets may be more fully valued than not.

This is especially the case when the price/earnings ratio for the S&P 500 is currently 24.7, using earnings over the past twelve months, according to Dow Jones data. A year ago, the P/E ratio was 20.9. The long-term history for this measure is 16.7 since the 1870s. Put a different way, earnings would have to increase by roughly 50% to bring stocks back to their long-term P/E average.

Now consider the nearby graph that looks at the sentiment measures I mentioned earlier - how bullish or bearish investors are - with certain technical indicators[i], or "internals," contained within patterns of stock price movements, courtesy of BMI Research.

Sentiment and Technicals Portray Signs of Risk

So, if there are risks to the market - and we're not making a forecast of a specific outcome - then investors might want to consider how well risks are diversified when using bonds. So, even though Treasury bonds may yield a bit less than corporate bonds, there may be some advantages to using them if your purpose for owning them is diversification. And of course, recall the caveat above that sometimes, risks can present themselves for both stocks and bonds simultaneously, no matter the credit quality. A prime example would be a larger than expected increase in inflation that might lead to a faster pace of rate hikes by the Fed than what the market currently expects.

The bottom line is that U.S. Treasury bonds are assumed to be the ultimate risk-free security (other than, of course, pertaining to interest rate risk). If one is attempting to diversify risky assets through a bond position, well then, perhaps quality should be a top consideration.

Disclosure: Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change, and they reflect those of the author and not necessarily United Capital. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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[i] The bullish sentiment factor is defined by a reading of 2x or more on the Investor Intelligence bull-bear ratio, and the weak internals are defined as the percentage of stocks being at or below the current level of 77%, and the percentage of new 52-week highs being at or below the current 7% on a 5-day moving average (with strong internals being when both of these metrics are above current levels). Source: BMI Research.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.