High-quality bonds, especially US Treasury and agency mortgage bonds, have proved the best diversifiers for equity exposure over the past several decades. The reason is intuitive: Demand for Treasuries often spikes when investors are seeking safety. Moreover, interest rates often decline during such periods, which has provided another tailwind for government-bond prices.
Yet, 2022 demonstrated that bonds aren’t a foolproof diversifier for stocks. As interest rates rose, bond prices dropped at the same time stocks did, and the correlations between the two major asset classes rose. The good news is that high-quality taxable bonds returned to form as a diversifier for equities in 2025, with the correlations between the two asset classes declining. That was a key takeaway from our latest research paper examining correlations among major asset classes.
As Amy Arnott noted in this article, bond prices could continue to be volatile. With war in the Middle East causing elevated energy prices, inflation worries have come to the fore again in 2026, and long-term bond prices may well remain volatile. That suggests investors with near-term spending needs, including retirees who are actively drawing on their portfolios, should hold cash and short-term bonds alongside their core intermediate- or long-term fixed-income holdings.
Recent Performance Trends: Taxable Bonds
With yields ultralow for much of the past decade, bond returns have generally been meager. Through the end of December 2025, the Morningstar US Core Bond Index had logged an annualized return just shy of 2%. While bond prices suffered painful declines as the Federal Reserve began to increase interest rates to combat inflation in 2022, those higher yields have translated into better returns for bond investors, as well as better downside protection. The Morningstar US Core Bond Index has gained nearly 4% (annualized) over the past three years.
With 2022 in the rearview mirror, correlations between stocks and high-quality bonds have been declining, but they’re still not back to pre-2022 levels. For example, the three-year correlation between US stocks and long-duration Treasury bonds was negative 0.35 at the end of 2021, but it sat at 0.65 at the end of 2025. As bond correlations increased amid rising interest rates, cash stood out as a reliable diversifier. Cash has had the lowest correlation with stocks over the past three years.
Consistent with their long-term pattern, higher-yielding, higher-risk fixed-income types, such as high-yield bonds and emerging-market debt, have also exhibited very high correlations with stocks.
Recent Performance Trends: Municipal Bonds
Because of their yields and general price stability, municipal bonds, issued by state and local municipalities to fund projects like airports and hospitals, have historically done a decent job of diversifying US equity exposure. Their long-term correlations with stocks have tended to be on par with core bond indexes but not as low as those of Treasuries or cash. Owing to a prolonged period of ultralow bond yields, munis’ returns over long time frames are modest: Through the end of December 2025, the typical intermediate-term muni fund had gained just 2.1% on an annualized basis over the past decade.
But things began looking up for muni investors starting in 2022. While Fed rate hikes crunched the prices of all types of bond funds that year, they ushered in higher yields. Moreover, recently declining interest rates led to a bond rally in 2025. As a result, three-year muni returns are now well above the inflation rate.
Municipal bonds’ rolling three-year correlations had often been negative with US equities, as they were from January 2016 through February 2020, but the pandemic introduced anxieties about how the economies of state and city municipalities would open and what their revenue would look like in a world reshaped by lockdowns. As a result, correlations relative to equities turned positive and have stayed there.
The rolling three-year correlations of munis with the US stock market are now well above those of taxable US core bonds. Munis’ correlation with stocks is also substantially higher than the correlation between Treasuries and US equities. While taxable bonds’ correlations with US stocks have declined a bit over the past year, munis’ correlations with stocks remain elevated.
Longer-Term Trends: Taxable Bonds
Recency bias might cause an investor to balk at the usefulness of US Treasuries in a portfolio. But over the long term, US Treasuries and other high-quality government-backed fare, such as agency mortgages, remain some of the most compelling diversifiers for a portfolio. When interest rates are stable or falling, these offerings provide a modest but reliable return that balances the volatile swings inherent in stocks. Cash has also earned its keep as an equity diversifier. Riskier allocations such as high-yield and emerging-market debt, on the other hand, serve as poor diversifiers relative to equity.
Longer-Term Trends: Municipal Bonds
Since 2000, most muni-bond indexes have exhibited a correlation with equities that was higher than that of US Treasuries and other government-backed fare but lower than investment-grade corporate credits. But in periods of equity market volatility driven by a weakening economy, municipal bonds have decoupled from Treasuries and other US government bonds, likely on concerns that higher unemployment and weak business conditions would hurt tax receipts. For example, the spread between muni yields and US Treasury yields widened significantly in early 2020.
Munis’ correlation with stocks has risen sharply since 2020. There are a few reasons for that. One is that nearly all fixed-income assets, including municipal bonds, saw their correlations with stocks jump in 2022. Moreover, the muni market is less liquid than the US Treasury market, and it has often seized up in periods of economic and equity market stress. As a result, munis have been less effective diversifiers for equities than US Treasuries or cash. High-yield munis had historically been the least effective diversifiers for equities of any muni-fund group, but now high-quality munis’ correlations are in the same range.
Portfolio Implications
A portfolio constructed for long-term resilience will be well served by a high-quality government-bond allocation—in particular, one with US Treasuries and agency mortgages. The 2022 experience also illustrates the virtue of cash in a balanced portfolio, particularly for investors who are retired and actively drawing upon their portfolios for living expenses. While cash might not earn much over inflation over long periods of time, a modest allocation can provide both safety and liquidity when stocks and bonds fall simultaneously.
Similarly, high-quality munis have typically held up much better than stocks during periods of economic weakness. As mentioned above, though, munis have generally exhibited a higher correlation with equities than high-quality taxable-bond indexes, especially US Treasury bonds. That suggests that even investors who value the tax-saving features of muni bonds should consider augmenting them with cash and US government bonds for diversification and ballast during equity market shocks. It also underscores the importance of not using a muni fund as a source of liquid reserves; any bout of illiquidity in the muni market would be an inopportune time to sell. (Municipal money market funds can be a better home for short-term liquidity for investors in high tax brackets.)