Do long-term bonds hedge equity risk? Evidence from Spain

Abstract

[Abstract:] We analyze the relationship between returns on equity and long-term government bonds in the Spanish economy. In particular, we are interested in the stability of the relationship across differing market conditions and if long-term bonds deliver diversification benefits during periods of equity market turbulence. Employing a Markov-switching vector autoregression model with three regimes, we find that Spanish bond returns become more positively correlated with domestic equity returns during periods of financial distress. A sectoral analysis reveals that two sectors – Financials and Oil & Gas – are responsible for this positive comovement with the former being relatively more important.