An edited version of this blog was originally published in the Financial Times on 22 December 2020.
In a year when investors questioned whether a traditional mix of stocks and bonds, the so-called 60/40 portfolio, is obsolete, the closely watched benchmark1 for the strategy delivered 11% returns as of 15 December. This follows three decades of annualized returns of 7.6%, despite ever-falling interest rates and concern that the secular bull market for interest rates was over. The new year will inevitability bring new concerns for bonds, and the question remains whether 60/40 portfolios can continue to deliver a fitting return for investors, and more specifically whether bonds offer an effective complement to riskier asset classes, like equities.
Returns over the secular horizon may be harder to achieve, but bonds will still play a very important role in portfolios. Indeed, bonds have offered diversification and volatility suppression (see Figure 1) in multiple-asset portfolios, which could be especially beneficial in the years ahead as a bumpy recovery and secular shifts in the global economy create much greater volatility than the market has experienced over the last decade.
Figure 1: All-stock portfolios tend to have higher volatility than stocks and bonds together
Traditionally, investing in fixed income assets, like U.S. Treasuries, offered the dual benefit of yield enhancement as well as diversification for those investing in multiple assets. The fixed, reliable yield of U.S. Treasuries has averaged 4% over the past three decades, which has complemented the total return of multi-asset portfolios. In fact, 2.3% of the return from the above 60/40 multi-asset portfolio over the past 30 years has come from fixed income. This return carried little risk of capital loss, providing investors with exposure to some stability during periods of volatility in riskier portions of the portfolio.
This historic hedging property of fixed income has helped make the 60/40 portfolio popular. While equities over the past three decades have returned 8.8% per year, volatility2 of the asset class has been high – 15%, with three periods of drawdowns where the market, as measured by the MSCI ACWI Index, fell in excess of 30%. While a high-returning asset class, equities can also inject substantial risk into portfolios, and diversification across the asset class often fails when it is needed most.
Bonds, however, have provided a ballast. Over the past two decades, the correlation between stocks and bonds largely has been negative (see Figure 2), meaning when stocks have fallen, bonds have typically risen. This negative correlation, or dampening effect of bonds, has delivered volatility to the above multi-asset portfolio of 9.1% over the past 30 years, which is 5.9 percentage points lower than the all-stock portfolio.
Figure 2: Bond returns remain negatively correlated to stocks
These historical relationships between stocks and bonds, however, are under stress in today’s low, or some cases negative, interest rate world. Volatile periods when investors seek “safe havens,” however, such as markets experienced in the first quarter of this year, have stress tested fixed income as an equity hedge amid ultra-low rates. Despite a low starting point for yields at the start of 2020, fixed income still performed as expected as a diversifier of risk. In the case of Germany, 10-year Bund yields started 2020 already slightly negative and then plunged to a record low -0.86% during the COVID-related volatility in the first quarter. Moreover, U.S. Treasuries have historically provided a positive nominal return in all U.S. recessions over the past five decades.
In the years ahead, market volatility is likely to be higher than experienced over the past 10 years, particularly as monetary and fiscal accommodation wanes, inflation gradually rises and trade deglobalization and populism remain potential political destabilizers. Moreover, economic and market disruption brought about by technological change and demographic shifts will lead to fatter market tails and higher levels of uncertainty. It will therefore be crucial for most investors to maintain exposure to volatility dampeners, like bonds, in their portfolios to help offset equity risk during times of stress.
With regard to yield enhancement, traditional fixed income such as developed-market nominal yields offer little opportunity to deliver attractive yield. The policy action and risk aversion in response to COVID-19 has forced developed-market sovereign bond yields to even lower levels. Instead, investors are finding that they must target specific regions and parts of the yield curve in order to maximize return and diversification potential. There are opportunities in high quality assets receiving policy support, such as agency mortgage-backed securities and AA/AAA rated investment-grade corporates, emerging market hedged local bonds as well as diversifying alternative strategies.
By deconstructing the value of fixed income into its two subcomponent parts – 1. a hedging asset, and 2. a yield asset – investors can create a well-diversified fixed income portfolio that can still provide tremendous benefit to multi-asset portfolios.
For detailed insights into our views across asset classes, read our December 2020 Asset Allocation Outlook, “Early Cycle Investing: Navigating the Growth Rebound.”
Erin Browne is a managing director and portfolio manager in the Newport Beach office, focused on multi-asset strategies.