Stock market sell-offs can be rough and they can pop up seemingly without warning. That is arguably what happened with the market to close out 2018, as many were surprised by the intensity of the sell-off in what has, often times, been a favorable time of the year for investors.
Events do not seem likely to calm down in 2019 either. Trade tensions, political worries and concerns over Fed policies look likely to dominate the headlines for much of this year too.
Given this reality, investors may want to consider some strategies for any future sell-offs and asset classes that might be able to act as counterweights to U.S. equities when the next downturn hits. One that has historically been an interesting choice is the world of short-term bonds.
Short-term bonds in stock market sell-offs
Generally speaking, when the S&P 500 has dipped into correction territory, it has fallen a bit more before entering a recovery period, at least based on history. On average, the S&P 500 has slumped another 6.86% after experiencing a 5% drawdown, suggesting that there usually wasn’t a quick turnaround for equities after falling by that initial five percent. Meanwhile, short-term bonds have delivered a positive return during S&P 500 drawdowns, acting as an effective counterweight to sluggish trading in equities.
Source: Morningstar Inc., as of 12/31/18, unless otherwise noted. Performance is historical and does not guarantee future results. Short-term bonds are represented by the Bloomberg/Barclays U.S. Aggregate 1-3 year bond index. Index returns assume reinvestment of all distributions and do not reflect fees or expenses and it’s not possible to invest directly in an index.
Not only did short-term bonds rise when S&P 500 equities fell, but they produced a correlation of just 0.01 with stocks. This means that short-term bonds have moved almost completely independent of equities, a characteristic that can come in handy when equities are in a slump.
Not just correlation
However, the potential benefits of short-term bonds do not end at correlation. These securities have also historically produced favorable Sharpe ratio as well. In a study of market data over the past 10 years, short-term bonds easily produced better risk-adjusted returns—as measured by the Sharpe ratio—when compared to other bond maturity levels. They also out-produced U.S. large cap stocks as well, by a significant 50 basis points.
Source: Morningstar Inc., as of 12/31/18. Performance is historical and does not guarantee future results. Intermediate-term bonds are represented by the Bloomberg/Barclays U.S. Aggregate 7–10 year bond index. Short-term bonds are represented by the Bloomberg/Barclays U.S. Aggregate 1–3 year bond index and long-term bonds are represented by the Bloomberg/Barclays U.S. Aggregate 10+ year bond index. Maturity is the date on which a debt becomes due for payment. Index returns assume reinvestment of all distributions and do not reflect fees or expenses and it’s not possible to invest directly in an index.
In other words, short-term bonds simply do not have the same risk profile that we see in equities or longer-duration fixed income. While it is true that other asset classes have produced superior numbers on a raw return basis, taking risk into account should recalibrate the equation for investors.
What it comes down to is that short-term bonds have simply been more efficient for delivering returns per unit of risk to investors on a historical basis. This efficiency—particularly if markets remain volatile—could be valuable for investors, especially in the next market slump if historical trends hold into the future (also read Are markets becoming more volatile?)
Bottom line
The most recent market correction might be over, but it never hurts to contemplate what might happen to your portfolio the next time one hits. One way to consider potentially shielding yourself is with short-term bonds.
These securities have historically shown a strong ability to move independently of stocks, and have provided solid returns when adjusted for risks as well. Given this impressive history, it may be an interesting asset class to consider for those seeking a counterweight to any potential sell-offs that may hit equities this year or beyond.