Can Bonds Still Diversify Multi-Asset Portfolios? Income versus Duration in Distinct Correlation Regimes

We analyze the diversification benefits of fixed-income instruments under time-varying correlations. We estimate monthly, non-overlapping correlations from daily 10-year Treasury bond returns over the period January 1962 to May 2025. With these data, we use a hidden Markov model to identify three distinct correlation regimes, negative, zero, and positive. These regimes are highly persistent and differ in their diversification value depending on the importance of income versus duration as drivers of bond returns. Dynamically altering the mix of multi-asset portfolio allocations based on the most likely correlation regime materially improves returns while controlling risk.