Why bonds may not save investors from the next market shock: Chart of the Day

Bonds are supposed to be the boring part of a portfolio.

They pay income, dampen volatility, and help offset stock market pain when investors run for safety.

But Morgan Stanley cracked open 150 years’ worth of stock and bond data and found the catch. When inflation runs hot, bonds have historically become less reliable as a stock market shock absorber — and inflation is still running hot enough to keep that risk alive.

A classic 60/40 portfolio — 60% stocks, 40% bonds — is built on a simple idea. Stocks drive long-term growth. Bonds provide stability when the ride gets rough.

That playbook broke down after the stock market peaked at the end of 2021.

The S&P 500 total return index — the blue line in the chart — has surged well above its early-2022 level. A 60/40 portfolio — in red — has also climbed back above that starting point, but with much less force. Meanwhile, the Bloomberg Aggregate Bond Index — in yellow, a broad measure of high-quality US bonds — has only clawed back to roughly where it began the period.

That actually flatters bonds a bit. The bond index had already peaked before the chart begins and still has not fully recovered.

The pain has been even clearer in long-term bond funds like the iShares 20+ Year Treasury Bond ETF (TLT), which has been pushed back toward pre-financial-crisis prices.

Inflation broke the old playbook

When inflation jumped, the Federal Reserve raised interest rates aggressively. Higher yields helped make bonds more attractive for income, but they also hammered bond prices.

That is the basic bond math. When yields rise, older bonds with lower payouts become less attractive, so their prices fall.

The same higher yields also pressured stocks by making future profits worth less in today’s dollars and tightening financial conditions across markets. In 2022, stocks and bonds fell together instead of offsetting each other. Stocks later recovered much more quickly, but the bond side never delivered the same rebound.

Morgan Stanley found the inflation switch

The firm found that inflation has historically been the biggest driver of how stocks and bonds move together. The market term is correlation, which simply means two investments tend to rise and fall together or move in opposite directions.

For balanced investors, negative correlation is most helpful. Stocks fall, bonds rise, and the portfolio gets a cushion. Positive correlation is the problem. Stocks fall, bonds fall, and the cushion gets thinner — or worse, turns into a drag.

Morgan Stanley found that when inflation moved above 2.4%, stocks and bonds tended to move more in the same direction.That is the line investors should care about now.

Headline inflation is still running hot at 3.8% — well above that threshold — and the market is still facing the kinds of shocks that can keep pressure on bonds, including higher oil prices, fiscal stress, tariff uncertainty, and renewed concern that the Fed’s next move could be a hike instead of a cut.

Bonds are not dead

Bonds still have a place in many portfolios, especially for investors who need income and are not counting on big capital gains from rising bond prices. Higher yields have made that part of the bond story more attractive again.

The harder question is protection.

If the next market shock comes from weaker growth or recession fears, bonds may still do their old job. Yields could fall, bond prices could rise, and portfolios could get the cushion investors expect.

If the next shock comes from inflation, oil, government deficits, or another interest rate scare, bonds may leave investors with a paycheck, not a parachute.

Jared Blikre is the global markets and data editor for Yahoo Finance. Follow him on X at @SPYJared or email him at jaredblikre@yahooinc.com.

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