Rethinking Fixed Income Asset Allocation

Explore ways to unlock a more dynamic allocation framework which can offer versatility for both negative and positive stock-bond correlation regimes.

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Overview

The post-pandemic landscape has ushered in an era of high inflation and interest rate volatility leading to increased stock-bond correlations ― a stark departure from the negative correlations of the previous two decades. Our nimble systematic approach aims to enhance portfolio resilience. We propose a novel method of blending tilting and timing in asset allocation to generate portfolios seeking a more consistent return profile.

The role of the stock-bond correlation (“SBC”)

Changes in the U.S. macroeconomy post-pandemic have ushered in a regime largely unfamiliar to most investors. For over twenty years, price of stocks and bonds typically moved in opposite directions making bonds a reliable diversifier in portfolios. This inverse relationship began to change in 2021 with stock-bond correlation (“SBC”) turning positive. What followed in 2022 was the fastest and most aggressive monetary tightening since the Volcker shock resulting in rare simultaneous downturn in stocks and bonds leading to historically poor performance (see below).

Figure 1: Annual U.S. equity and bond returns

Source

The return of bonds are based on the annual return of 10-year U.S. Treasury Bond. Stocks are represented by the total return of S&P 500 Index from 1957 onwards. Prior to 1957, the returns are based on price changes in S&P Composite Index. Source: BlackRock, with data from LSEG Datastream as of May 31, 2024. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index.

Traditional asset allocation approaches

In our systematic framework, “tilting” refers to strategic, long-term asset allocation aimed at capturing risk premia during low-volatility and expansionary phases, while “timing” is a faster, tactical approach designed to generate returns in volatile markets or economic transitions. Together, tilt and timing may create portfolios with more consistent return profiles, as timing can help offset tilt underperformance during turbulent periods, while tilts can add value when volatility is muted and risk premia are stable, so both strategies may be suited for navigating the full range of market cycles and crises.

Revisiting asset allocation frameworks for positive SBC regimes

Grappling with the task of developing insights for a relatively unfamiliar positive SBC regime, investors can look back to the early 60s to include periods of high inflation and positive SBC in research. This approach may enable the testing and validation of new insights that are robust and can navigate risk on/off and risk parity on/off regimes. We define a “Risk On/ Risk Off” (R2) factor and a “Risk Parity On/ Risk Parity Off” (P2) factor.

Negative SBC Regimes

Investors may maximize the R2 factor’s return by going long risky assets and short safe assets, generating the largest gains in risk-on periods and the largest losses in risk-off periods.

Positive SBC Regimes

Investors may maximize the P2 factor’s return by taking long positions in both risky and safe assets, generating the largest gains in risk-parity-on periods and the largest losses in risk-parity-off periods.

By expanding our research to cover data from the 1960s and tapping into sophisticated machine learning techniques, we’ve developed a framework that captures SBC regime shifts without directly estimating the SBC parameter, aligning with the risk on/off and risk parity on/off factors.

To verify the efficacy of these insights, we examine the average performance of timing R2 and P2 factor across various regimes. We construct R2 and P2 factor as a two-asset portfolio made up of 5-year High Yield CDX as the risky asset and 10-year U.S. Treasury Note Future as the safe asset. We then modulate the exposure of these factors using our timing indicators and measure their performance through time.

The bar chart in below shows the performance of each timed factor across return quintiles for a buy and hold of R2 and P2 portfolios.

Figure 2: Portfolio timing returns in R2 and P2 factor return quintiles

For tilt, we use a blend trend-following and carry/vol based approach, balancing the defensiveness of trend following with risk seeking and aiming for higher return profile of carry/vol.

We look at correlation between tilt and timing to ensure their additivity. The chart below displays the rolling 252-day correlation. The average correlation over performance window is -14%. The low or slightly negative correlation between tilt and timing suggests that together, they can enhance risk-adjusted returns and generate a more consistent return profile across SBC regimes.

Figure 3: Correlation between tilt and timing

Source

Notes: 252-day correlation between tilt and timing returns measured over period July 31, 2006–March 31, 2024. Correlation statistics from a stylized back-test for a hypothetical two-asset tilt portfolio containing U.S. 10-year Treasury Note Future and 5-year U.S. High Yield CDX rebalanced daily. Asset returns based on TY1 Comdty and Markit CDX.NA.HY 5-year Excess Return Index. Performance measured over period July 31. 2006–March 31, 2024. Correlation statistics from a stylized back-test for a hypothetical two-asset tilt portfolio containing U.S. 10-year Treasury Note Future and 5-year U.S. High Yield CDX rebalanced daily. Asset returns based on TY1 Comdty and Markit CDX.NA.HY 5-year Excess Return Index. Performance measured over period July 31, 2006–March 31, 2024. Risk and return statistics are reported annualized using monthly data. Growth and inflation regimes defined using difference between 3-month and 6-month average for U.S. Manufacturing PMI and headline CPI YOY respectively. Interest rate volatility regimes defined using ICE BofA MOVE Index. Risk regimes defined using Chicago Board Options Exchange Volatility (VIX) Index. Risk parity regime returns calculated for a hypothetical inverse volatility weighted portfolio of S&P 500 Index and Bloomberg Barclays U.S. Treasury Index. Performance measured over period July 31, 2006–March 31, 2024. Source: BlackRock, with data from Bloomberg. For illustrative purposes only. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

This presentation contains back-tested data for the indices listed above. Unless otherwise noted, returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Hypothetical data results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance and cannot account for risk factors that may affect actual performance. The back-tested past performance returns are shown for illustrative purposes only and are not meant to be representative of actual performance returns of any account, portfolio or strategy. The back-tested performance period is from July 31, 2006–March 31, 2024.

The securities or asset classes in the back-tested portfolios were selected with the full benefit of hindsight, after their performance returns over the period shown was known. It is not likely that similar results could be achieved in the future. Back-tested performance returns have certain limitations. Unlike actual performance returns, they do not reflect actual trading, liquidity constraints, fees and other costs. Back-tested performance returns are indicative of a hypothetical portfolio rebalanced daily. No representation is being made that any account, portfolio or strategy will or is likely to achieve results similar to those shown.

Our systematic asset allocation framework can adapt to market conditions by emphasizing tilts in stable markets and focusing on timing in periods when outcomes are driven by tails of asset return distribution.

The chart below shows how a combination of tilt and timing would have yielded better risk adjusted performance with an information ratio of 1.26 vs. 0.85 for tilt and 0.82 for timing. The correlation statistics highlight the additivity from combining a defensive timing overlay to a traditional risk on tilt as measured by lower correlation to broad market betas.

Figure 4: Cumulative simulated returns of tilting + timing

Conclusion

The post-pandemic shifts in interest rates and inflation have reshaped market dynamics, requiring investors to revisit long-standing asset allocation strategies. By studying past periods of high inflation and positive SBC, investors can gain insights for more adaptive approaches across varying regimes. A systematic, data-driven allocation framework rooted in economic sensibility can potentially deliver more consistent outcomes amid unpredictability.