How to diversify your portfolio as bonds fail investors
The correlation between stocks and bonds has been positive since 2022 after decades of being negative. How should asset owners react to the seeming break-down of the traditional portfolio? (Michael Nagle/Bloomberg)
It has long been one of the most widely held assumptions in investing: a portfolio made up of stocks and bonds – the 60/40 portfolio – will provide adequate diversification.
But the changing positive relationship between stocks and bonds is prompting institutional investors to revisit this most basic assumption in portfolio construction: that fixed income will reliably offset equity risk.
Recent analysis from AQR Capital Management shows how much of a problem this has caused: the correlation between the two asset classes crossed from negative to positive in 2022 but since then they have been getting ever more closely correlated.
It now sits at 0.53 (a correlation of one of course being a perfect positive correlation while a correlation of minus one being a perfect negative correlation).
This trend is largely driven by inflation shocks—has led some investors to mistakenly boost equity exposure, assuming bonds no longer provide diversification.
The firm warns that substituting bonds with assets like private credit may actually increase portfolio risk rather than improve diversification. Its central point is that equity risk has always dominated portfolios, even in a traditional 60/40 portfolio.
In AQR’s view the issue is not correlation itself but the underlying level of equity beta—suggesting investors should focus less on shifting correlations and more on how much their portfolios are truly exposed to stock market risk.
“Investors should focus less on how many slices their asset allocation pie has and more on each slice’s underlying risk factors,” said Dan Villalon, principal and global co-head of portfolio solutions at AQR, told AOX. “For most portfolios, the dominant risk factor is the health of equity markets. This means the first question to ask when evaluating a diversifier is how much of its returns are independent of the direction of equities.”
That perspective may be gaining traction as allocators confront a more volatile macro environment. When stocks and bonds fall together, traditional frameworks like the 60/40 portfolio provide less protection, exposing investors to deeper drawdowns.
But rather than abandoning diversification, some institutions are refining how they define it, focusing more on underlying risk exposure and equity beta than on asset class labels.
Despite questions about its diversification role, fixed income is not being pushed aside. If anything, higher yields have made it more attractive.
According to Ricky Pamensky, executive vice president and head of fixed income at Meketa Investment Group, many institutions are maintaining or even increasing their bond allocations following recent asset allocation reviews.
With interest rates now well above the ultra-low levels of the past decade and less likely to revert to pre-2022 levels, high-quality investment grade bonds are once again capable of generating mid-single-digit returns, he says, helping pensions move closer to their typical return targets without taking on excessive risk.
This shift has repositioned fixed income as more than just a hedge. For Pamensky, it “may place an increased role in return generation, reducing the need for excessive risk-taking elsewhere in the portfolio.”
Asset owners are seeing that play out in real time.
“The rate environment has made fixed income an advantageous place to find yield again,” said Greg Petzold, executive director of the Police and Firemen’s Retirement System of New Jersey. Rather than making aggressive bets on interest rates, he suggested the fund is prioritising flexibility and scenario planning so it can respond quickly.
At the same time, allocators may be taking a closer look at how different parts of their portfolios actually behave. A key concern raised by AQR is that some assets often viewed as diversifiers, such as private credit or structured products, may still carry significant equity-like risk.
In practice, Pamensky says institutions are not simply swapping out bonds for another diversifier.
Instead private credit and real assets are typically being added alongside traditional fixed income, not in place of it. Still, moving lower in the capital structure can increase sensitivity to equity markets, particularly below investment grade credit.
According to Pamensky, investors are increasingly willing to take on incremental risk within their portfolios, particularly when seeking diversification away from equities or aiming for modestly higher returns.
“That shift has been observed in areas like below-investment-grade multi-asset credit strategies,” said Pamensky, “These strategies can still provide meaningful diversification relative to traditional equity exposure, even as they sit further out on risk.”
For some asset owners, alternatives continue to play the central role in managing equity risk. Petzold noted that his fund remains largely indexed on the public equity side, relying instead on alternatives such as private credit and infrastructure to provide downside protection and diversification benefits over long time horizons.
“Historically alts have done the heavy lifting and outperformed when equities hit a rough patch,” said Petzold.
Portfolio decisions are also constrained by return targets, which often sit around 7 per cent. That leaves limited room to dial back exposure to growth assets without jeopardising long-term goals.
As a result, demand for private markets and credit strategies remains strong, even as investors scrutinise how much diversification they truly provide. Credit opportunities in particular are drawing attention, though investors acknowledge that underwriting has become more complex in the current environment.
There is also renewed interest in hedge funds and total return strategies, especially as volatility rises, though adoption varies widely across institutions.
For consultants like Pamensky, the market has begun to differentiate between investors that built resilient balance sheets and adaptable business models versus those whose performance was more dependent on the low-rate environment.
“From a capital structure perspective, moving lower [down the credit rating scale] does introduce increased sensitivity to equity-like risks as investors are closer to the equity layer, but it remains a distinct risk profile,” said Pamensky.
Is this shift permanent? According to AQR that is uncertain but there are reasons to think the positive correlation may remain a feature for some time yet, particularly in the wake of the US conflict with Iran.
“If inflation expectations stabilise again, we’d expect a return to a negative correlation,” they said. “That said, it’s possible that the recent oil shock and the challenges to Federal Reserve independence may de-anchor inflation expectations, keeping this correlation positive a while longer.”
Pamensky said: “For the correlation to turn negative again, the most likely path is inflation returning sustainably to the Fed's 2 per cent target. This would give it the flexibility to cut aggressively in a downturn. A hard landing where growth deterioration simply overwhelms inflation concerns could also do it, though that would likely be temporary and unstable.
“We do not see this resolving in the near term. It could take several years or more, but it is uncertain. The forces that argue for persistence include deglobalisation trends keeping inflation volatility elevated and fiscal concerns around US debt levels and potential rotation away from Treasuries.”
The breakdown in the traditional stock-bond relationships is less a temporary disruption and more a reminder that diversification depends on the broader economic regime.
The classic 60/40 model is not obsolete, but its effectiveness is no longer guaranteed. For asset owners, the focus is shifting toward the need to think beyond asset class labels and focus on underlying sources of risk and return when markets are under stress.