Stock-Bond Correlation: Theory & Empirical Results

Stock-bond correlation is an important component of portfolio allocation. It is widely used by institutional investors to determine strategic asset allocation, and is carefully monitored by multi-asset fund managers to implement tactical asset allocation. Over the past 20 years, the correlation between stock and bond returns in the US has been negative, while it was largely positive prior to the dot-com crisis. 

Investors currently believe that a negative stock-bond correlation is more beneficial than a positive stock-bond correlation because it reduces the risk of a balanced portfolio and limits drawdowns during periods of equity market distress.

In this study, we provide an overview of stock-bond correlation modeling. In the first part, we present several theoretical models related to the comovement of stock and bond returns. We distinguish between performance and hedging assets and show that negative correlation implies a negative bond risk premium due to the covariance risk premium component. In contrast, the payoff approach can explain that bonds can be both performance and hedging assets. In addition, a good understanding of the stock-bond correlation requires an assessment of the relationship between the aggregate stock-bond correlation at the portfolio level and the individual stock-bond correlation at the asset level. Macroeconomic models are also useful in interpreting the sign of the stock bond correlation. They can be divided into three categories: inflation-centric, real-centric, and inflation-growth based.

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