Exploring the equity–bond relationship in a low-rate environment with unsupervised learning

Abstract

Some investors have become concerned about the low-interest-rate environment and its impact on the role that bonds play in a multi-asset portfolio. In order to analyze the equity hedging property of government bonds, we apply a simple but powerful machine learning technique called k-means clustering to periods with low interest rates. Our findings show that government bonds have historically acted as intended in an equity–bond portfolio, with typically positive bond performance in equity-down scenarios. Although there are some periods in which both equities and bonds fall, these can be viewed as ordinary parts of market volatility and distinct from the typ-ical outcomes that can be considered as recurrent market states. The results of this alternative and complementary approach – which has not, to the best of the authors’ knowledge, been used before to study equity–bond diversification benefits – supple-ment the existing literature by providing further evidence of the added value that bonds bring to a strategic multi-asset portfolio.