IMF | Stock-Bond Diversification Offers Less Protection From Market Selloffs

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Diversification has become harder since 2020 as stocks and bonds tend to move in tandem during sharp selloffs, adding to financial stability concerns

Spreading investments across asset classes can reduce risk and smooth returns. The classic diversification between stocks and bonds worked historically because they moved in opposite directions. When stocks fell, investors sought safety in bonds. Bonds rallied, cushioning losses and stabilizing portfolios.

Since the start of the pandemic period—with supply shocks that fueled inflation—bonds have become less effective in cushioning volatility in stocks. Instead of offsetting equity risk, bonds are increasingly moving in tandem with stocks. This shift is particularly pronounced during sharp market selloffs, with profound implications for investors and policymakers alike.

The breakdown of this historical relationship makes diversification—such as the classic portfolio, of 60 percent stocks and 40 percent bonds, or risk parity strategies—vulnerable to shocks. Hedge fund and risk parity investment strategies that employ leverage based on the historical relationship are now increasingly moving in tandem with Treasury returns, which could make them vulnerable to forced deleveraging. Even conservative institutional investors like pension funds and insurers could be exposed to greater portfolio volatility during market corrections.

Corrections tend to be sharp, accompanied by a surge in stock market volatility. This amplifies systemic vulnerabilities as volatility can feed into selloff dynamics by worsening investors’ funding constraints and forcing deleveraging.

Looking back, our analysis shows that the turning point for correlations came around the end of 2019. With the onset of the pandemic the following year, the historical relationship changed significantly, resulting in sharp selloffs of both stocks and bonds to occur more frequently together.

From 2000 to 2019, the inverse relationship between expected stock and bond returns helped investors effectively manage risk. Tracing standardized expected returns for stocks and bonds against the VIX shows a clear divergence: As volatility rises, expected returns for equities increase as stock prices fall, while expected returns for bonds decline as bond prices rise. This was the foundation of diversification strategies.

The changed relationship since 2020—with both asset classes tending to sell off concurrently in response to rising market stress—reinforces equity risk in the United States as well as, to varying degrees, Germany, Japan, and the United Kingdom.

This breakdown may explain the severity of recent market selloffs: losses compound when both assets fall together.

The diminished hedging properties are increasingly evident in the sharp rallies in gold, silver, platinum and palladium, as well as currencies such as the Swiss franc. Gold, for example, has more than doubled since the start of 2024 as investors sought alternative safe havens in recent months. Platinum and palladium jumped in the final quarter of last year, reflecting diversification shifting toward non-sovereign stores of value.

Diminished protection 

Amid the hedging breakdown, higher volatility coincides with higher expected bond returns, with prices declining steeply in the current period as investors reprice term premiums.

Over the past few years, expanding bond supply to finance widening fiscal deficits across most advanced economies, which we also explored in the October 2025 Global Financial Stability Report,has heightened investor concerns. At the same time, gross issuance of bonds has outpaced central bank balance-sheet runoff, that is, bonds maturing without reinvestment.

With central banks reducing holdings via runoff, a larger share of bond supply must be absorbed by price sensitive private investors. This gap has become more evident since late 2023 as central banks’ balance sheet runoff slowed while issuance stayed elevated. Overall, the supply absorbed is many times larger than the reduction in central bank holdings over the past few years in the four largest advanced economies.

With inflation still above target in many economies, fiscal concerns increasingly raise term premiums as investors see bonds as riskier, eroding their suitability for hedging. Investors may demand higher compensation for holding longer maturities, reinforcing upward pressure on term premiums and further eroding hedges.

With fiscal expansion expected to continue, this upward pressure may be reinforced if corporate capital investment is increasingly financed by debt issuance. These effects could be reduced by greater productivity growth, bringing down inflation and allowing government to issue bonds with shorter maturities.

Policy challenges

Central banks will undoubtedly intervene to stabilize bond markets during periods of extreme stress, but this has limits. Relying on emergency measures can lead to excessive risk-taking and undermine market discipline.

A more durable solution, restoring the hedging properties of sovereign bonds, requires fiscal discipline. High debt levels globally and uncertain fiscal trajectories weaken the safe-haven status of government securities. Without credible fiscal frameworks, bonds cannot serve as reliable anchors in turbulent markets.

Central banks also must commit to ensuring price stability. The unexpected rise of inflation since 2020 has been a key contributor to the reversal in stock-bond correlations.

Regulators should also incorporate correlation breakdown scenarios into stress tests. Financial institutions need to prepare for traditional diversification to fail, as models calibrated on historical correlations may underestimate new risks.

Rethinking risk

With diminished diversification, investors must build portfolios that account for the shift in correlations. Alternative strategies—such as incorporating commodities or private assets—may offer partial solutions, but they come with their own complexities and risks.

Policymakers face even greater challenges. Maintaining financial stability amid high correlation risk requires credible fiscal and monetary policy frameworks, robust stress testing, and clear communication to anchor expectations. If diversification fails, volatility can cascade into broader financial instability. Investors and policymakers must rethink risk management for a new era where traditional hedges fail.

Authors:
• Tobias Adrian, Financial Counsellor and Director of the Monetary and Capital Markets Department, IMF
• Johannes Kramer, Senior Financial Sector Expert in the International Monetary Fund (MCM Global Markets Analysis), IMF
• Sheheryar Malik, Deputy Chief in the IMF’s Monetary and Capital Market Department, Global Markets Analysis Division, IMF

Compliments of the International Monetary Fund