Rethinking Bonds in a Changing Macro Regime

It’s not just whether to own bonds, it’s how to own them

“Stocks and bonds slump in tandem as Iran shock leaves investors ‘nowhere to hide’” read the headline on the FT. “Traditional 60-40 portfolio of global equities and fixed income on course for worst month since 2022” was the subheading.

The performance of bonds in March has quickly brought back the uncomfortable memories of 2022 – a year when bonds and equities both suffered significant drawdowns, producing the worst year in decades for the 60/40 portfolio.

The discomfort is all the more acute given how differently markets behaved in February. Just over a month ago the idea that AI would be radically disinflationary saw bond yields fall and bonds rally. The long -duration Treasury ETF TLT was up 4% in a month when equities were down. It was as if bonds had resumed their traditional place in multi-asset portfolios as the dominant hedge to equity exposure.

But the war in Iran has prompted a re-assessment. Stagflation fears have resurfaced amid the negative supply shock of much higher energy prices. In March, equities were down over -5% and TLT was down -4%.

The bond sell-off has reignited the debate about the role of bonds in portfolios.

The traditional view is they remain a core holding based on safety and yield. The alternative view is that a changed macro regime means the bond equity correlation has structurally flipped and bonds are a less reliable diversifier for equities and should be avoided.

Rolling 3-year correlation S&P 500 and US Treasuries

For investors, the conundrum is: what is the optimal allocation in an environment where the macro regime is less favourable but potentially more volatile?

The answer is not a lot but not zero and, more importantly, tactically managed.

The importance of the macro regime

The idea of bonds as a core holding alongside equities has become almost a fundamental rule of investing. The 60-40 equity bond portfolio is widely seen as the benchmark balanced portfolio. But it hasn’t always been like this. Bonds’ role as a hedge to equities is a product of the macro regime. It is not a stable relationship; it depends on the inflation and policy backdrop.

In fact, between 1950 and 2000 the correlation between bonds and equities was positive. During World War II the Fed suppressed yields via yield curve control. But that stopped after the Fed Treasury accord of 1951 and US yields began a multi-decade increase.

Average Monthly Performance of Bonds When the S&P 500 was down more than 2%

The 1960s and 1970s saw rising inflation, and bond yields trended higher meaning bonds didn’t serve as a hedge against equities.

In fact, in the 1960s and 1970s, in months when the S&P 500 was down more than -2%, the average monthly performance for bonds was -0.4%.

The macro regime then changed with Volcker’s rate shock in 1979, the fall of the Berlin wall, globalisation and China’s entry to the WTO. By the 2000s we were in the globalised disinflationary era of the Great Moderation and bonds became the great hedge for equities.

In the 2010s, in months when the S&P 500 was down more than -2%, the average monthly performance for bonds was +2.2%.

But since 2020 the macro backdrop has shifted again. It’s a regime of higher government spending, supply shocks and structurally higher inflation. US inflation has now been above the Fed’s target for five years with core inflation settled at 3.0% over the last 12 months.

Since 2020, in months when the S&P 500 was down more than -2%, the average monthly performance for bonds was -1.6%.

Positive Correlation, Higher Volatility, Higher Drawdowns

The impact of the change in landscape for bond investors is doubled-edged. On the one hand the shift has translated into higher yields meaning higher current income. But from a portfolio perspective the positive correlation means bonds offer less diversifying value to equity-heavy portfolios.

That upshot is that the volatility of the standard 60-40 has increased. Between 2000-2019, the annualised volatility of the US 60/40 portfolio was 8.2%; since 2020 it has jumped to 11.8%.

Critically, what comes with higher volatility is higher drawdowns.

In major equity drawdowns between 1990 and 2020, replacing 40% of an equity portfolio with an allocation to government bonds meaningfully reduced the total drawdown of the portfolio. For example, after the dotcom boom imploded, equities declined 45% peak to trough, but a US 60-40 declined by only -21%.

S&P 500 and US 60/40 Drawdowns: Jan 1990 - March 2026

But in 2022, when equities had a 24% drawdown, bonds offered less diversification: the US 60-40 portfolio still endured a drawdown of -20%. In fact, 60-40 portfolios that used long duration bond funds such as TLT suffered a bigger drawdown that a long equity only portfolio.

The specific case of credit

And the issue of coincident drawdowns between equities and bonds becomes even more accentuated when one tilts the bond portfolio to credit rather than government bonds.

Investors are often tempted to move into credit to boost yield. But the further down the credit spectrum you go, the lower the diversifying value of the bonds.

That’s because in an economic downturn, the likelihood of default increases and credit spreads widen reducing bond values.

In 2022 the drawdown for a US 60/40 portfolio using LQD ETF (high grade corporate bonds) instead of IEG ETF (US Treasuries) was -22.7% versus -23.9%. Investors in high yield bonds suffered larger drawdowns.

The case for the bonds

The experience of 2022 has rightly shone a light on the inherent limitations of 60-40. It’s an approach that worked very well in a particular macro era. And that era is now gone.

But does that mean have zero allocation to bonds? Not necessarily.

There are three reasons to maintain bond allocations despite the changed regime.

The obvious one is yield. Starting yields are the best indicator of future returns and for the US starting 10-year yields of 4.3% point to a reasonable expectation of nominal returns of something similar over the next 10 years.

If inflation averaged the Fed’s target that would mean real returns of 2.3% pa. Given that inflation has been above the Fed’s target for 5 years now, it seems reasonable to expect inflation to average more than 2% pa over the next decade, but TIPS offer real yields over 2%.

If one was particularly negative on equities over the next decade given heightened valuations, bond allocations could conceivably be justified on an expected return basis.

And, even in the 1970s, the higher yields at times offset the capital losses to generate positive returns. For example, bonds had positive total returns in 1973 and 1974, when equities sold off, even though yields rose in both years.

The second reason is that even if we remain in the current macro regime of supply shocks and sticky inflation, it is not impossible that we get periodic demand led downturns where inflation declines when growth weakens, allowing central banks to ease and bonds to rally.

Third, we could see a shift in the macro regime. That seems less likely given the structural trend of higher defence spending, higher government spending and supply constraints. But only in February did the market consider the possibility of a disinflationary positive supply AI shock.

It’s not inconceivable that an adverse supply shock (such as the war in Iran) driven economic downturn could be accentuated by AI related job losses. That scenario could be initially stagflationary but then deflationary.

Against that other tail scenarios need to be considered. The assumption that higher yields translate into higher total return rests on the assumption that bonds are repaid at par.

But in a world of fiscal dominance and financial repression that assumption could also be questioned. In a fiscal crisis, not only might the authorities resort to higher inflation to reduce the real value of debt, but restructuring and defaults could be conceivable.

Re-thinking bond allocations

For investors thinking about building robustness and resilience it’s clear that a changed macro regime requires a fundamental rethink of the size, composition and nature of fixed income exposure.

It’s not just a matter of owning less bonds but how to own them. A total portfolio approach requires thinking about how bond exposure and duration risk is obtained across the portfolio, not just through core allocations.

Many multi-asset portfolios may already have duration risk via other asset classes like infrastructure and high growth stocks. But those exposures mix economic growth risk with duration.

Hedge fund allocations can provide a more direct way to get active fixed income exposures. For example, allocating to global macro or systematic trend following provides tactical regime dependent active exposure to bonds. That may be an effective way of layering active bond exposure on top of a smaller core allocation.

The benefit of that approach is that it provides a natural mechanism for the portfolio adapting to any regime shift. If we are in a prolonged regime of rising yields, trend strategies will tend to stay short bonds. But if at some point if the regime changes and deflation takes hold, trend strategies would adapt to that as soon as the scenario is reflected in price trends.

Conclusion

The changed macro environment doesn’t mean bonds will never work as a diversifier to equities, but it does mean they are a less reliable diversifier for equity portfolios.

The case for credit is even weaker given the tendency to correlate with equities even more in economic downturns.

In a more unstable macro environment, static allocations are less reliable. That argues for using dynamic adaptive strategies to modulate fixed income exposure alongside smaller core holdings. The question is not just whether to own bonds, but how to own them.

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