Are Bonds Still a Good Diversifier?

Have bonds regained their role as an effective diversifier for equity portfolios? Where does cash fit into today's asset-allocation discussion? 

Morningstar portfolio strategist Amy Arnott and director of personal finance Christine Benz examine how correlations between stocks and bonds have evolved over the past year, and which fixed-income sectors have provided the strongest support during market downturns. 

We also explore municipal bonds, why cash has stood out as a portfolio stabilizer, rising-rate pressures, and what recent market behavior may mean for diversification across asset classes.

Our latest research on building a diversified portfolio includes:

• A comparison between the performance of diversified portfolios vs. 60/40 portfolios in the 2025 market 
• Analysis between asset-class correlations during higher interest rates, inflation, and economic slowdowns 
• Deep dives into 12 major asset classes and their role in a portfolio

Amy Arnott: Yeah, as you mentioned, you worked on that section on fixed-income asset classes. What are some of the key trends that you wrote about there? 

Christine Benz: Well, one of the big ones is that leading up to 2022, that correlation relationship that you could take to the bank was that high-quality fixed-income was a good ballast for equities. If equities were down, especially in recessionary environments, high-quality bonds were a good place to be. 

In 2022 though, the wheels came off on that thesis. And we saw correlations, because of rising rates, bothering both stock and bond prices at the same time. We saw correlations between high-quality fixed-income and and stocks come much closer together, become much higher during that period. 

The good news in the very recent past—so over the one-year period through the end of 2025—was that we started to see correlations widen out again. Fixed-income again appeared to offer good diversification for that all-equity portfolio. So that is, I think, a positive thing for investors using those core building blocks. 

And then another recurrent theme of the past several years of research is just that cash appears to be a really good diversifier for that stock/bond portfolio. And the year 2022 really showed that in stark relief where we had stocks down, bonds down—as a cash investor with higher yields coming online, you were the winner in that environment because you actually got to have a higher return in a period that was hurting other core asset classes. 

So those are kind of the headlines from the 2025 experience.

Arnott: And what have we been seeing so far in 2026?

Benz: It's interesting. It's been a bit of a tough go of it for fixed income. There I think there are concerns that the Fed may be a little less accommodative in the face of higher inflation. And so it's something worth keeping an eye on. We've seen long-duration bonds get crunched during this period.

The good news for fixed-income investors though is that because yields are higher, even if their prices suffer some short-term dislocations in periods of higher yields, you at least have your higher yield to cushion the blow to help reduce the downward pressure on prices. So that's a plus for fixed-income investors.

Arnott: So if you're looking across the fixed-income landscape, which asset classes have been the most helpful or the least helpful in terms of offering diversification for someone who owns US stocks?

Benz: Generally speaking, the high-quality fixed-income instruments, mainly those anchored in US government bonds, agency-backed bonds, those have been some of the best ballast for equities, especially in those recessionary bear markets for stocks. They've been quite reliable. Not every day—there have been some short-term price dislocations, but they've been pretty good ballast for equities. They will tend to be vulnerable though in those rising rate shocks like we saw in 2022.

But if you're looking for that category that will provide you with some solace in a long-running bear market for your equity portfolios, high-quality fixed-income is is a good place to be.

Cash, as I mentioned, while not a bond, is still something worth holding as well alongside your fixed-income investments.

And then in the category of things that have been less helpful, it's about what you would expect. So those equity-like fixed-income investments, especially high-yield bonds, anything lower-quality. Bank loan investments will tend to be a less effective ballast. You might hold them because of their attractive yields or for other reasons, but they wouldn't be the thing that you would want to hold to diversify your equity exposure.

Arnott: The paper also includes a section on municipal bonds. And one of the interesting takeaways there is that muni bonds, even though they might be attractive for people in higher tax brackets who are focusing on income, they really haven't provided as much diversification as other types of fixed-income securities. Can you expand on what's driving that?

Benz: It was a little bit of a head scratcher to me, Amy, because high-quality municipal bonds are really considered second only to Treasury bonds in terms of their creditworthiness. But we have seen the correlations between municipal bonds and equities increase quite a bit since the 2022 period, and unlike high-quality taxable bonds, they've remained tightly correlated.

So, we haven't seen correlations come down in the way that we have with taxable bonds. So, I think it may be that the municipal market is less liquid than is the case for taxable bonds, certainly government US government bonds.

There also is more issuance in the intermediate and long duration area. So, if we're concerned about rising rates, maybe that is driving some of the continued high correlations there.

Arnott: And how have munis been holding up so far this year?

Benz: Well, it's pretty similar to the story that we've been seeing in the taxable bond space, where the intermediate and long-term munis have gotten crunched a little bit here. But like with taxable bonds, they have the advantage of today's higher yields that help cushion some of those price losses.