Stock-bond Correlation Research Articles

International stock–bond correlations in a simple affine asset pricing model

We use an affine asset pricing model to jointly value stocks and bonds. This enables us to derive endogenous correlations and to explain how economic fundamentals influence the correlation between stock and bond returns. The presented model is implemented for G7 post-war economies and its in-sample and out-of-sample performance is assessed by comparing the correlations generated by the model with conventional statistical measures. The affine framework developed in this paper is found to generate stock–bond correlations that are in line with empirically observed figures.

The Price of Bond Market-Stock Market Correlation Risk

Bonds are attractive investment instruments that complement a broad-based equity portfolio. As the correlation between stocks and bonds increases, investors lose diversification benefits. Stocks that pay out more in states in which the aggregate stock-bond correlation is high will be deemed more attractive and their expected returns should be lower. Our hypothesis is then that the stock market-bond market correlation is a risk factor. To test this, we extract the riskless bond-stock market correlation using several different methods that include the BEKK and the Dynamic Conditional Correlation methods. We examine the price of bond-stock correlation risk in the cross section of stock returns. We find that aggregate correlation carries a statistically significant negative price of risk of about 3 percent that cannot be explained by the market return, size, book-to-market, default spread, term spread, unexpected inflation and other known risk factors.

International Stock-Bond Correlations in a Simple Affine Asset Pricing Model

We use an affine asset pricing model to jointly value stocks and bonds. This enables us to derive endogenous correlations and to explain how economic fundamentals influence the correlation between stock and bond returns. The presented model is implemented for G7 post-war economies and its in-sample and out-of-sample performance is assessed by comparing the correlations generated by the model with conventional statistical measures. The affine framework developed in this paper is found to generate stock-bond correlations that are in line with empirically observed figures.

Asset Allocation in a Lower Stock-Bond Correlation Environment

The correlation between stock and bond returns plays a critical role in asset allocation decisions and in the effectiveness of stock-bond diversification in reducing portfolio risk. During the last few years, the realized stock-bond correlation has trended lower than historical norms, and the current 36-month rolling estimate is significantly negative, while most analysts still assume a moderately positive equilibrium estimate for expected correlation. Many investors are now questioning their assumptions about correlation and whether lower correlation will continue. This decoupling of stock and bond returns combined with aggressive asset allocation strategies has contributed to deterioration in pension plan funded ratios, producing unfavorable impacts for investors with an economic liability. The various strategic and tactical asset allocation issues related to a continued low correlation environment have an impact on investor welfare in an asset-only and an asset-liability framework. For investors, low stock-bond correlation is beneficial in an asset-only context, but detrimental in the case of a bond-like liability, especially if there is significant underfunding of the liability.

Stock-Bond Correlations

The correlation between stock market and government bond returns was positive through most of the 1900s, but negative in the early 1930s, the late 1950s, and recently. If the trend is sustained, the shift to a negative correlation should boost government bond valuations owing to bonds9 attractive hedging characteristics. This exploration of sources of stock-bond correlation examines asset class behavior in different economic conditions. Growth and volatility shocks tend to push stocks and bonds in opposite directions, while inflation shocks tend to cause common discount rate variation across asset classes. The latter effect dominated in the variable inflation levels of 1960–1990 and kept stock-bond correlations positive. As long as inflation rates remain low, low correlations should prevail. Correlations become even more negative during deflationary recessions, equity weakness, and high-volatility flight to quality periods.

The Stock-Bond Correlation and Its Implications for Asset Allocation

(1990). The Stock-Bond Correlation and Its Implications for Asset Allocation. Financial Analysts Journal: Vol. 46, No. 4, pp. 55-60, 79.