Will Bonds Deliver Crisis Alpha in the Next Crisis?

Will Bonds Deliver Crisis Alpha in the Next Crisis?

June 7, 2016 Guest Posts, Macroeconomics Research
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(Last Updated On: June 7, 2016)

Bonds are often viewed as being great diversifiers due to the perception that they perform well during tough times for stocks.

Historically this has been a true statement. But will it continue?

Our answer: unclear.

Most investors use correlation to measure the diversification benefit an investment might provide an existing portfolio.  However, this article uses a slightly different approach to measuring diversification – Crisis Alpha.  Crisis Alpha, as defined by Dr. Kathryn Kaminsky in her articles (and fantastic book Managed Futures the Search for Crisis Alpha), is the excess return of an asset (the asset’s return less the return of cash) given that the US stock market is in “crisis,” meaning it has declined by more than 5% in a month.

Crisis alpha in simple terms: How much does an investment return above cash when US stocks had an especially bad month?

For example, in August 2015 the S&P 500 declined 6.03% (it was quite a bad month).  In the same month, the Ibbotson Associates US Government Long-Term TR index returned 0.12% while cash returned 0%.  This means that the Crisis Alpha for the Ibbotson Associates Government Long-Term TR index is 0.12% (0.12% – 0% = 0.12%) for the month of August 2015.

Alternative Crisis Alpha Measurements

As astute readers, you might be asking yourself the following questions:

  • Why use excess returns instead of the total return of the asset?
    • We use the excess return because it is important to isolate the return of cash (historically it’s always been more than 0%) from the return of the asset in excess of cash.  We do this because the return of cash is a common component of all investment assets (and has historically always been positive), we remove it to attempt to isolate the extra return (risk premium) that each investment provides.
  • Why not use correlation to measure the diversification benefit?
    • We use crisis alpha because correlation is constantly changing and evolving over time.  In addition, most people don’t want diversification in up markets (they want the whole portfolio to be up together) but do want diversification in down markets (since this will provide some downside protection).  Crisis Alpha helps isolate people’s diversification preferences by only looking at how different asset classes have performed in down markets.
  • Why are you defining Crisis Alpha as the excess return of an asset class when stocks were down more than 5% in a month?
    • There are different ways you can define Crisis Alpha (drawdown of stocks of more than X%, months where VIX increases more than X%, etc.).  We choose this method as it provides a large number of measurement periods across history.

Core results

We use data from Ibbotson Associates for this analysis.  Specifically, we use Ibbotson Associates US Large Cap Stocks TR for stock returns, Ibbotson Associates 30 Day T-bill TR for the return of cash and Ibbotson Associates US Government Long-Term TR for the return of bonds.  Unless otherwise specified, all monthly returns are arithmetic and all returns are excess returns (total return for the month less the return of cash for the month “ER”). The data period is from 1/1926 to 4/2016.

Bond Crisis Alpha Table
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Here is a visual depiction that makes the result more clear:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

What we see when we look at investment returns through the lens of Crisis Alpha is that stock returns are considered “normal” (stocks have a return greater than -5%) in about 90% of months.  However, in about 10% of months stocks lose more than 5%.

In the months where stocks have a return greater than -5%, they have an arithmetic average return of 2.05% and in months where stocks lose more than 5% they have an arithmetic average return of -9.02% (this makes sense as they have to have at least a -5% return to make it into this category).

We also see that, historically, cash has averaged a total return of about 0.28% in “normal” months and 0.24% in Crisis Alpha months.  The attribute of having a positive return in Crisis Alpha months provides fantastic diversification to a stock portfolio.

Moving on to bonds, we see that historically bonds have provided a 0.21% excess return over time and have had a positive excess return in 56% of all months.  In “normal” months bonds have provided a 0.22% excess return and had a positive excess return 56% of the time.  In Crisis Alpha months, bonds provided a 0.12% excess return and had positive excess return 56% of the time.

When we view bonds through the lens of Crisis Alpha, a couple of characteristics emerge:

  • Bonds do provide some diversification benefits – they provide positive excess return in Crisis Alpha months
  • However, the diversification benefit of bonds may be smaller than people realize – bonds have produced a positive excess return only 56% of the time in Crisis Alpha months (no more frequent than in “normal” times) and they have only provided an excess return of 0.12% in Crisis Alpha months (compared with 0.22% for “normal” months).
  • Surprisingly, bond excess returns decrease during Crisis Alpha months! Even though bond excess return don’t go negative, they have followed the same return pattern of stocks (stocks are just far more dramatic) where their returns are greater in “normal” times than they are during Crisis Alpha months.

We can study the return characteristics of bonds even more closely by decomposing bond returns into two different pieces 1) income return and 2) price return and analyze how the components behave during “normal” months and Crisis Alpha months.

We use the Ibbotson Associates Long-Term US Government Bond Capital Appreciation TR index for the price return component and we derive the income return component as difference between the US Long-Term US Government Bond TR index and the Ibbotson Associates Long-Term US Government Bond Capital Appreciation TR index (i.e., total return – price return = income return).  We then subtract the return of cash from the income return series to make it an excess return.

Bond Component Crisis Alpha Table
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

And here is the visual:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

There are some interesting observations to make when analyzing the components of bond returns:

  • Historically, the majority of bond’s excess returns have come from the income component of returns not price changes.
  • Historically, the income return component has delivered positive excess return in almost 90% of the months, including Crisis Alpha months.
  • Historically, bond price changes have actually been negative (on average) during Crisis Alpha months! Given that bond price changes have been positive about 52% of Crisis Alpha months, the negative average return is due to some less frequent large losses during Crisis Alpha months.

What might these results imply for an investor today?

Bonds do diversify a stock portfolio – they have historically provided a positive excess return during Crisis Alpha months. This means that an investor looking to diversify stock risk in their portfolio should own some bonds.

Although bonds diversify a stock portfolio, they have not been a fantastic diversifier.  Historically, bonds have returned only 0.12% per month above cash during Crisis Alpha months, which isn’t that large of a return!  In addition, bond excess returns during Crisis Alpha months have been positive only 55% of the time. This means that they don’t consistently provide positive return during times when diversification is most needed.

Historically, bond performance during Crisis Alpha months have been dominated by the income return component. The income return component delivers more than 100% of the Crisis Alpha month performance and the income return component is positive almost 90% of the time.

Historically (and surprisingly), the price return component of bond returns is negative during Crisis Alpha months!

Today, we have lower yields and the duration of bond indices is much longer than average. These changes may impact how bonds perform during Crisis Alpha months in the future which will affect the diversification benefit of bonds:

  • Because bond yields are lower than historical average this decreases the income return we can expect from bonds. Given that the income portion of returns has historically comprised more than 100% of the return of bonds during Crisis Alpha months, this means that bond performance during Crisis Alpha months going forward is likely to be more muted.
  • Bond index durations are longer than they have been historically. This means that the price component of bond returns will likely be a larger component of returns going forward.

Having price changes compose a larger portion of bond returns going forward isn’t good for a couple of reasons:

  • Bond price performance isn’t likely to be very large (historically it is only 33% of bond total performance).
  • Bond price performance during Crisis Alpha months has actually been negative historically!
  • Bond price performance during Crisis Alpha months has only been positive about 52% of the time.

This analysis shows that bonds have provided some diversification benefit (positive performance during Crisis Alpha months) historically but that going forward, we may want to lower our expectations of bond performance during Crisis Alpha months.  It might be time to start looking for other investments or investment strategies to generate positive excess return during Crisis Alpha months.


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Andrew Miller CFA, CFP

Andrew Miller, CFA, CFP: Andrew is Chief Investment Officer at Miller Financial Management, LLC where he is primarily responsible for investment and financial planning research, asset allocation, and integrating client’s financial plans with their investment portfolio. Andrew is a Chartered Financial Analysis and is a Certified Financial Planner® practitioner. Andrew graduated from the Indiana University Kelley School of Business in 2004 with a Bachelors degree in Business Administration with a concentration in Finance. Andrew’s research interest is in using academic investment research to create investment portfolios that improve the withdrawal rates and financial outcomes for clients.


  • JAK78

    I don’t know why you would be surprised that long-term bond excess return would decrease during crisis alpha months. There is a strong desire for safety during those times, and long term bonds are anything but safe. I would have preferred to see this analysis done with intermediate or short-term bonds. I suspect you would have gotten very different results.

  • Greg Player

    This was/is my take too. Let’s look at the “safe” asset as something different than cash (one extreme) and long-term bonds on the other extreme. The availability of different classes of bonds, and different duration of bonds make for a lot of options in selection of a bond asset during crisis periods.

    I have always been interested in how the correlation of assets changes during crisis periods – which this analysis supports. Using long-term correlations is the easy analysis, but that the out of sample actuals is anything but aligned with historical experience.

  • Andrew Miller

    Using Ibbotson Associates Intermediate Term Government Bond index tells a similar story. The historical average excess return is 0.15% per month. The excess return in “normal” months is 0.15% and the excess return in Crisis Alpha months (historically) has been 0.2%. In crisis alpha months, the income return has been 0.1% and the price return has been 0.1%. Excess return has been positive 67% of the time in Crisis Alpha months for the time series. The income return component has been positive 89% of the time in Crisis Alpha months while the price return component has been positive 60% of the time in Crisis Alpha months.

    The reason why Long-Term Government Bond index was used is because its price return series contains little roll-down return component (i.e. that portion of the yield curve has been pretty flat historically) whereas the Intermediate Term price series has a large portion of roll-down return (that portion has been upward sloping historically). I am trying to highlight contemporaneous yield changes as opposed to yield changes and roll-down return.

    As for long-term bonds being risky, they are volatile and have a large component of interest rate risk. The risk shown here is stock market risk (totally different risk). Considering how well long-term bonds did in 2008 (long-term treasury index up 22.5% or so), this is an effort to highlight that long-term bonds don’t always perform that well during Crisis Alpha months and are even more likely not to repeat that type of performance going forward (i.e., What these results might imply for an investor today, above).

  • JAK78

    The numbers you present indicate the opposite of what you are saying. Intermediate term government bonds provide an excess return of 0.20% during Crisis Alpha and 0.15% normally, while long-term government bonds give only 0.12% during Crisis Alpha and 0.22% normally. Intermediate bonds returned more than long bonds during Crisis Alpha. They also returned more during Crisis Alpha than they returned during normal times, while long bonds returned less during Crisis Alpha than in normal times. Also, the the 67% of the time that intermediate bonds earned positive excess returns during Crisis Alpha is higher than the 56% of the time that long bonds earned positive excess returns during Crisis Alpha. I don’t think stock market risk is the most relevant risk in these crisis situations. All risk matters then as investors overreact and seek a flight to safety.

  • Paul Novell

    Great post. Would be interesting to see if these results have changed over time? For example, over 5-10yr rolling periods. Basically, are modern markets different?

  • Andrew Miller

    The numbers indicate that intermediate term government bonds have historically delivered more excess return during crisis months than long-term government bonds. This is due to roll-return these bonds have earned historically. Roll down returns may not be there in the future as the yield curve flattens between the 2Y and 5Y (intermediate term). However, the point of the article is to study bond returns during periods of bad stock market performance, ipso facto stock market risk IS the relevant risk for this study.

  • Andrew Miller

    The two most recent crisis are different in that they have generated the majority of the crisis alpha…which is really the point of the article – bonds haven’t historically performed that well during crisis alpha months. The majority of the crisis alpha is generated from the income component (now not that great) and the price appreciation during the 2000-02 period.

  • JAK78

    The higher returns of intermediate bonds may also be due to their perceived safety with respect to long bonds during times of crisis that accentuate loss aversion. I prefer to go with what the data tells me has happened in the past rather than speculate on future yield curve effects on Crisis Alpha, which may not be relevant.

  • dph

    How have International markets looked while the US stocks are in “crisis” mode? I suspect they offer some diversity but not when world correlation converge like we saw in 08/09.

  • You got it.
    Anything equity related blows up in a real crisis. No place to hide.

  • Thanks for a very stimulating article.

    I have used the Shiller data to compare capital returns on equities and 10Y bonds since 1871, assuming a bond duration of 7 years. I then examine 10Y moving arithmetic mean crisis alpha. Since I do not have short-term rates for this period I define crisis alpha without reference to a risk-free rate, which makes my definition different from yours. I expect the conclusions below would still stand if I could use your definition.

    There are three regimes. 1881-1970, crisis alpha is close to zero. 1970-1992, crisis alpha is negative. 1992-present, crisis alpha is positive.

    This likely reflects different economic regimes: gold standard and Bretton Woods; inflationary 1970s, trailing into the 1980s; and 1990s to today, with central-bank inflation targeting.

    As long as we continue to have floating exchange rates and relatively-successful inflation targeting (at least in terms of capping inflation on the upside) it seems reasonable to expect decent crisis alpha from bonds.

  • glad you liked it.

    Agree that the crisis alpha aspect of bonds is time-varying. Tian, one of our analysts, identified the same thing…

    That said, Andrew’s insight is that a lot of the crisis alpha aspect is driven by cash yield, not price fluctuations.

    Interesting.

  • some follow on analysis. Here we look at 30yr zero, which has the max duration out there. Lots of crisis alpha, even without a cash coupon component

  • Andrew Miller

    One of the questions about assuming recent bond crisis alpha performance will continue – Why economically or theoretically should bonds have a negative correlation (or more importantly a convex) correlation to equities?

  • I think the negative correlation, given we are in chaos, is due to the “flight to quality” characteristics of an asset. And to the extent T Bonds continue to hold that quality, they’ll probably continue to get a boost when the rest of the world is in shambles.

  • Zach

    Thanks for sharing! It would be interesting to see a follow up article that showed some of the best performing crisis assets.

  • Grégory Guilmin

    Very interesting article. So, what’s the alternative(s) ? Are there real alternatives ?

  • Andrew Miller

    I’d check Wes’ link below or look at Wes’ post on their ROBUST risk management method: http://blog.alphaarchitect.com/2014/12/02/the-robust-asset-allocation-raa-solution/#gs.V5P3Q34

  • Hannibal Smith

    This might be more illuminating if your broke Crisis Alpha performance down by bond bear market 1940-1980 and bond bull market 1980 to date. How about it?

  • Check out the time series chart on the crisis alpha in a few comments below this one…Andrew posted a chart that should indirectly answer that question

  • Hannibal Smith

    This is confusing. Two lines are labeled the same. I assume the orange line is the risk free rate?

  • Hannibal Smith

    Yet, all of these dates are post-1980 in a bull market. That’s not informative unless conditions remain the same and after 36 years now with negative rates, thats a stretch.

    Could you basically do what you did at this http://blog.alphaarchitect.com/2015/08/19/crisis-alpha-surprising-ways-to-hedge-stock-portfolio-risk/ but use 10-year, 20-year, 30-year and Zero Coupon? It needs to be all in one place for easy comparison.

  • IlyaKipnis

    Volatility trading.

  • You may consider constructing a diversified portfolio of markets and strategies. Going forward, government bonds may not come to rescue a portfolio with a high allocation to stocks.

    More importantly, it may make more sense to go with whatever trend is going when crisis shows up. We don’t know which markets will trend up or down. The alternative to a “set and forget” strategy may be to adapt to the trends and not place too blindly trust and follow past data.

  • In addition to trend following and U.S. Treasuries, some other examples of asset classes that have historically produced positive returns and lower correlation during bear markets are MLPs, Gold, TIPs, Municipal bonds.

  • Nice research.

    In many cases, investors allow the period from 1992-now to determine how they make decisions going forward forever. More likely, investors have not done the research further back in time like you have. If they did, they may see that bonds are no guarantee.

    Going forward, we don’t know how bonds will react in crises. Instead of making some long term prediction and making a big bet on it now, it may make sense to follow the trends (wherever they go) as they come. If bonds go down in the next stocks bear market, then you can adapt to that and get out or even go short.

    Assuming the law of the markets is that bonds will perform well in the next stock market crisis because it has generally done that in the past 24 years may classify as reckless depending on who you ask.

  • Instead of implementing a fixed allocation to bonds, you may consider a more dynamic approach where they move in and out of your portfolio based on the trend. This way, you do not have to make a long term call or prediction on what bonds will do in the next crisis. When the next crisis pops up, if bonds go down then get out (if you’re long), stay out or even go short.

  • I like your questions and attention to detail.

    Yes, regarding the orange line, I assume the same thing.

  • By “international markets” I assume you mean “international stocks”. During U.S. crises, international stocks suffer losses as well.

    You may consider looking into international government bonds in addition to treasuries. They provide their own diversification benefits and who knows – they may provide better crisis alpha than treasuries in the future. Do not let the hometown bias work against you.