Higher stock-bond correlation: Silver lining for pension investors?

Sep 2, 2018

Low correlation between stocks and bonds is one of the bedrocks of portfolio diversification. For investors primarily concerned with maximizing total returns and minimizing volatility, periods of low correlation are welcome, while spikes in correlation can test both portfolio returns and investor resolve. For liability-driven pension investors, however, higher stock-bond correlation may have a silver lining: an improvement in funded status.

Correlations between equities and bonds have varied dramatically over the last 10 years, ranging from approximately -0.8 to 0.2. See the chart. The level of correlation can have a meaningful impact on a pension’s funded status, particularly during an equity market sell-off, a scenario that is now top of mind for some funds as the equity bull market approaches its second decade and the Fed continues to raise interest rates.

The chart demonstrates how a 10% decline in the S&P 500 would affect the same pension portfolio at different correlation levels. The pension’s funded status suffers a much smaller decline when correlations are higher.

How stock and bond correlations impact funded status

Rolling one-year correlation of S&P 500 returns and 10-year U.S. Treasury returns

Source: BlackRock, June 2018. The first graph shows the correlations of daily returns between equities and bonds over a rolling 252-day period, 40-day half-life. Equity returns are based on the S&P 500 index, while bond returns are based on the 10-Year U.S. Treasury. The second graph shows the changes in funded status, which are quoted as a percent of asset value and calculated using BlackRock Solutions Aladdin risk model based on the trailing 252 daily observations, with a 40-day half-life. The change in funded status is computed by shocking the S&P 500 by 10%, and all other factor moves are implied using a 252-day, 40-day half-life correlation matrix. We assumed the following composition for a typical pension portfolio: 21% Barclays Long Gov/Credit Bond Index (Fixed Income – Long), 21% Barclays Aggregate Bond Index (Fixed Income – Agg), 37% MSCI ACWI Index (Global Equity), 6% S&P Listed Private Equity Index (Private Equity), 6% HFRX Global Hedge Fund Index (Hedge Fund), 5% Dow Jones U.S. Real Estate Index (Real Estate), 4% Barclays 1-3 Month T-Bill Index (Cash). Liability returns are modeled to match risk characteristics of the Bank of America Merrill Lynch Mature US Pension Plan AA Index as a combination of the following indices: 60% Barclays Long Credit Bond Index, 23% Barclays Long Gov Bond Index, 17% Barclays Int Gov Bond Index. Past performance is not indicative of future results. Indexes are unmanaged, and it is not possible to invest directly in an index.

Why do pension portfolios benefit from higher stock-bond correlation?

When bonds sell off in tandem with stocks, interest rates go up, as do the rates at which pensions discount their liabilities, reducing the present value of those liabilities. When a pension portfolio is under-hedged to the interest rate risk of its liabilities, it is implicitly short interest rates. This net negative surplus portfolio duration means that the surplus portfolio would benefit from rising yields, which can help mitigate losses from equity-like assets in a market sell-off (see the August 2013 scenario in the chart). In a positive correlation environment, a plan with an interest rate hedge ratio of less than 100% may even see an improvement in funded status during a market sell-off, if the plan has greater risk exposure to fixed income than to equities.

Conversely, in times of negative stock-bond correlation, a fall in equities will be accompanied by a decline in yields, which will exacerbate the equity losses due to the pension’s implicit short position in interest rates (see the October 2011 scenario in the chart).

What determines stock-bond correlation?

Stock-bond correlation can be influenced by many factors including real rates shocks, inflation shocks, growth shocks and central bank credibility (see Shock Treatment below). Shocks in real rates and inflation have historically led to equities and bonds moving in the same direction, as their expected cash flows are both discounted at nominal rates. We saw this during the taper tantrum in 2013, when investors feared a disorderly rise in interest rates, and again in early 2018, when inflation expectations began to move higher.

Negative growth shocks, on the other hand, have led to equities and bonds moving in opposite directions as investors seek the perceived safety of bonds during periods of stock market turmoil. Finally, assuming a central bank is credible, stocks and bonds are more likely to experience lower correlation: central banks use interest rates to actively mitigate cyclicality as rates are typically raised to avoid overheating and lowered to accommodate credit expansion.

Shock treatment

General effects of market shocks and central bank policy on stock-bond correlations

General effects of market shocks and central bank policy on stock-bond correlations

Source: BlackRock, June 2018. For illustrative purposes only.

In the last several months, we’ve begun to see a pick-up in stock bond correlation. As you assess the risk in your pension portfolio, we encourage you to consider the role that correlation can play and to contact us if you’d like to discuss your plan’s needs in more detail.

Gabriella Barschdorff, CFA
Managing Director, Client Portfolio Solutions Pensions
Margarita Rabinovich, CFA
Associate, Client Portfolio Solutions Pensions