Morningstar - Q2 2021 - 30

Spotlight: Role of Bonds

Meanwhile, core-plus bond funds, which many
investors use as their core fixed-income
holdings, have provided less of a diversification
benefit with equities. That's because these
funds' portfolios are often heavy on corporate
and asset-backed bonds and may also
include a dash of lower-quality bond exposure.
High-yield bond funds have proved to be the
least effective equity diversifiers over the
past two decades, followed by bank loans and
emerging-markets bonds.
Portfolio Implications
While Treasury bonds have been among the best
diversifiers for equity exposure over the past
two decades, whether that will hold true is an
open question. In particular, one scenario that has
rarely been on display over the past three-plus
decades is a rising interest-rate environment.
If yields were to jump up, that could hurt equity
prices and would almost certainly punish
Treasuries, which, due to their highest credit rating,
tend to be extremely sensitive to interest-rate
changes. In other words, if stocks suffered losses
due to spiking interest rates, Treasuries may
be less effective as diversifiers as they've been
over the past few decades.
Another issue is that Treasury yields remain
ultralow today. Thus, while demand for
Treasuries may be elevated in an equity market

shock, Treasury-bond owners won't be able
to rely on their yields to provide much of a cushion
in volatile environments. In a related vein,
it's notable that cash has recently looked a bit
better than Treasuries from the standpoint
of diversification. That may be because as yields
have declined across the board for several
decades, high-quality bond yields have edged
toward zero, so bond prices simply don't
have a lot of room to move up. It may also be that
with yields on cash and Treasuries so tightly
aligned, investors don't view bonds as worth their
risks in a flight to quality.
It's also notable that TIPS have exhibited much
less diversifying abilities than have nominal
Treasuries over the past few decades. While
their correlation coefficient with equities is lower
than low-quality bonds, it's still positive and
much higher than nominal Treasuries. That pattern
makes intuitive sense, too, in that demand
for TIPS' inflation protection is likely to stall out
when worries about the economy are running
high and equities are dropping. In short,
while TIPS play a role for inflation protection,
investors haven't been able to rely on TIPS
to diversify their equity exposure. On the other
hand, inflation has kept a low profile for
the past decade. If stocks were to experience
weakness related to inflation, TIPS may confer
a greater diversification benefit.

Meanwhile, all manner of lower-quality bond
types are exceptionally poor diversifiers with
stocks. That demonstrates that they're best used
as supplemental holdings alongside highquality fixed-income investments, or perhaps
better yet, as equity alternatives.
Municipal Bonds
Municipal bonds are issued by state and
local municipalities to pay for infrastructure and
projects like hospitals and sports stadiums.
Taxpayers who purchase municipal bonds
can typically exclude the income (though not
capital gains) from their taxes.

Because the states and municipalities that issue
these bonds have taxing authority (and can
raise taxes to pay their bills), the creditworthiness
of high-quality municipal bond issuers is
typically considered second only to that of the
U.S. government and better than that of highquality corporate bonds. A key difference between
municipal issuers and the U.S. government
is that states and local governments cannot run
deficits. There have been a handful of
municipal bankruptcies, but they've been rare.
Municipal bonds-due to their yields and general
price stability-have historically done a
decent job of diversifying U.S. equity exposure.
Their long-term correlations with stocks have
tended to be on par with high-quality taxable-bond
indexes, but not as low as U.S. Treasury bonds'
correlation with equities.

EXHIBIT 2

Taxable Bonds as Diversifiers Treasury bonds have provided the best diversification
with equities of any taxable-bond type.
Rolling 3-Yr
Correlation
0.4

Morningstar US 1-5 Yr Treasury Bond
Morningstar US Cash T-Bill
Morningstar US Core Bond

0.06
0.0

2020 Correlations
In the flight to quality that characterized the
short bear market at the outset of the pandemic
in 2020, municipal bonds were notably
less effective diversifiers for equities than were
U.S. Treasury bonds during the period.
Whereas Treasury and other U.S. government
bonds exhibited a negative correlation with
equities, the correlation of munis with equities
was strongly positive.

-0.36
-0.4
-0.50
-0.8
01/2004

01/2007

01/2010

01/2013

01/2016

Source: Morningstar Direct. Data as of 12/31/2020. Correlations are versus the Morningstar US Market Index.

Morningstar Q2 2021

01/2019

Across muni-bond groups, correlations with
equities were about the same as the Morningstar
US Core Bond Index-about 0.85 over the
three-month period. High-yield municipal
bonds-those issued by states and municipalities

Morningstar - Q2 2021

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