For Diversification From Stocks, Cash Has Made a Good Case for Itself

High-quality bonds, especially US Treasury and agency mortgage bonds, have proved the best diversifiers for equity exposure over the past several decades. The reason is intuitive: Demand for Treasuries often spikes when investors are seeking safety. Moreover, interest rates often decline during such periods, which has provided another tailwind for government-bond prices.

Yet high-quality bonds haven’t been a foolproof equity diversifier, as bond-price bobbles in April 2025’s tariff-related downturn, 2022’s interest-rate hikes, and in the early innings of the pandemic illustrate. Instead, cash investments, while not technically bonds, have helped diversify equity exposure even better than bonds over the past several years. That suggests that investors augment their bond holdings with cash investments to cover near-term expenditures, or else construct a portfolio of individual bonds designed to mature in time to meet spending needs.

Those were key findings from our recently published paper examining correlations among major asset classes.

Recent Performance Trends: Taxable Bonds

The distinct and wildly divergent markets of the past three years tested the expectations an investor might have from a fixed-income portfolio. While bond correlations have dramatically increased amid rising interest rates, cash stood out as a reliable diversifier. The graph below depicts the correlation of various slices of the taxable-bond market relative to US stocks.

While both stock and bond prices stabilized in 2023 and 2024 after the painful drawdown in 2022, three-year correlations between stocks and high-quality bonds remain elevated. Treasury bonds, historically among the best diversifiers for US equities, are positively correlated with US stocks over the past three years. Longer-term Treasuries look particularly weak as diversifiers over the most recent three-year period. Cash had the lowest correlation with stocks, in part because it was a rare asset type to exhibit positive returns in 2022. Cash investors’ yields rose at the very time that stock and bond prices were falling.

Recent Performance Trends: Municipal Bonds

As with high-quality taxable bonds, municipal bonds’ rolling three-year correlations are often negative with US equities, as they were from January 2016 through February 2020, but munis’ correlations relative to equities turned positive and have increased steadily since 2020. The interest-rate increases that began in 2022, sending both stock and bond prices tumbling at once, further boosted equity and fixed-income correlations, including municipals.

The rolling three-year correlation of munis with the US stock market are roughly in line with those of taxable US core bonds. Munis’ correlation with stocks is also substantially higher than the correlation between Treasuries and US equities. High-yield municipal bonds had the closest links with stocks of any muni category, but the correlation was in line with those of investment-grade corporate bonds and lower than those of high-yield corporate credits.

Longer-Term Trends: Taxable Bonds

Cash has recently been one of the best diversifiers for US equities, with a substantially lower correlation to stocks than high-quality bonds. But over the long term, US Treasuries and other high-quality government-backed fare, such as agency mortgages, remain some of the most compelling diversifiers for a portfolio. When interest rates are stable or falling, these offerings provide a modest but reliable return that balances the volatile swings inherent in stocks. Riskier allocations such as high-yield and emerging-markets debt, on the other hand, serve as poor diversifiers relative to equity.

Longer-Term Trends: Municipal Bonds

Munis’ correlation with stocks has risen sharply since 2020. There are a few reasons for that. One is that nearly all fixed-income assets, including municipal bonds, saw their correlations with stocks jump in 2022. Moreover, the muni market is less liquid than the US Treasury market, and it has often seized up in periods of economic and equity market stress, such as the onset of the pandemic in March 2020. As a result, munis have been less-effective diversifiers for equities than US Treasuries or cash. Across all longer-term time frames, high-yield muni funds were the least effective diversifiers for equities of any muni fund group. That is similar to the trend for high-yield taxable bonds, which are much less defensive and more sensitive to economic stress than high-quality bonds.

Portfolio Implications

A portfolio constructed for long-term resilience will be well served by a high-quality government-bond allocation, in particular one with US Treasuries and agency mortgages. The 2022 experience—as well as 2025 thus far—also illustrates the virtue of cash in a balanced portfolio, particularly for investors who are retired and actively drawing upon their portfolios for living expenses. While cash might not earn much over inflation over long periods of time, a modest allocation can provide both safety and liquidity when stocks and bonds fall simultaneously.

Although bonds served as a source of portfolio pain in 2022, over longer periods and more typical interest-rate backdrops, a high-quality US government-bond sleeve improved diversification more often than it detracted from it. And US Treasuries aren’t exclusive in providing this counterbalance. Intermediate-term and short-term maturities of diversified high-quality bonds also provide some refuge when the US equity portion of a portfolio is under duress. Riskier fixed-income subsectors, such as high-yield, nonagency mortgages, and emerging-markets debt, are highly correlated with stocks and should be seen as equitylike complements to a portfolio.

As with taxable bonds, high-quality munis have typically held up much better than stocks during periods of economic weakness. That said, over longer periods, munis have exhibited a higher correlation with equities than high-quality taxable-bond indexes, especially US Treasury bonds. That suggests that even investors who value the tax-saving features of muni bonds should consider augmenting them with cash and US government bonds for diversification and ballast during equity market shocks. It also underscores the importance of not using a muni fund as a source of liquid reserves; any bout of illiquidity in the muni market would be an inopportune time to sell. (Investors in high tax brackets can use municipal money market funds in that role.) High-yield munis’ higher correlation with equities, meanwhile, indicates that such bonds are best used alongside higher-quality muni bonds (or high-quality taxable bonds) for investors aiming to diversify equity risk.