2020 has been a roller coaster for both fixed income and equity investors. As of Oct 28, the Barclays Aggregate has outperformed the S&P 500 by over 300 basis points year to date… but it has been a volatile ride.
Source: Bloomberg as of 10.28.2020
Looking back to Mid-March, from the view of a fixed income investor, an ugly side of bonds showed as the entire market entered a liquidation phase. The historical correlation benefits of bonds were nowhere to be found as equities tanked at record pace. A noticeable theme since the lows in March and over the last couple of weeks of market volatility has been how bonds have acted as a poor hedge against equity declines.
This has been largely concerning to investors, prompting an increase in articles claiming the 60/40 allocation is broken. We’d agree with Cameron Crise of Bloomberg’s article which timely follows one of the most volatile equity markets since March, Bond Traders Wonder If It’s Time to Leave Wonderland: Macro Man:
“What’s been notable about this week’s trading is how little solace portfolios have managed to find in bonds. While the full tale has yet to be written, this chapter at least has signaled a victory for the 60/40 prophets of doom.”
Source: Bloomberg as of 03.18.2020
2020 has seen the entire yield curve re-rate as interest rates have plummeted; specifically on the long end of the curve. In turn, long duration bonds have benefited precipitously (TLT up ~20% YTD through 10/28/20). The Fed has all but assured the market they plan to keep short term borrowing rates at zero percent for the foreseeable future. The Fed’s support has created an environment that we believe encourages greater risk taking as bond investors have few other choices.
We think the current bond environment creates significant longevity risk for client portfolios. Current yield levels have historically been a good indicator of future returns. From our perspective, things look pretty grim from here.
Source: Aptus Research and Bloomberg * Through September 2020
As we think about bonds from a reward to risk perspective just look at the math: The 30-year Treasury bond now yields ~1.6%, we believe that’s a fair estimate for what it will earn over the next few years. The low yield comes with high interest rate risk. For example, if a 30-year bond’s yield rose from 1.6% to 3.6% its price would fall 37%.
With most of the future returns of bonds being brought forward, where does that leave us?
With expected returns across the board lower, we believe advisors are tasked with building portfolios that address longevity risk, while suiting their clients volatility expectations and income needs. In our opinion, low yields inject new types of risk that most of us have never seen. Moving forward we believe more attention to detail is required to help address longevity risk… and this likely won’t be solved by a traditional 60/40 portfolio or by holding large cash positions.
Last week, Ray Dalio was featured on the Masters in Business podcast and gave some big picture thoughts on bonds and their positioning in portfolios from here:
Based on his discussion, bonds are too volatile relative to the tiny yields they offer — “one day’s price change is greater than one year’s yield,” Dalio said. Cash isn’t an alternative, either. “It doesn’t have the volatility to it, but what it does is — like now, it’s like a negative two percent a year,” he said, referring to inflation eroding its value. “So it’s this nonvolatile hidden tax at two percent a year. You look at the compounded effect of one or two or three percent per year on your life, and it is enormous.”
We believe Dalio’s comments on the current yield environment highlight the concerns that the 60/40 portfolio is broken. We certainly believe fixed income investors are in between a rock and a hard place. He also emphasized that holding too much cash creates excess exposure to the dreaded inflation tax. So what can advisors do given the hand they are dealt?
The current bond environment seems to create a problem that requires a different type of thinking. It is our belief that the solution comes from improving asset allocation. We seek to immediately improve our potential outcome by owning less of assets that have little to no expected return and more exposure to assets that do.
This embrace of “more equities”, with accompanying hedges, gives us some flexibility in moving away from the default 60/40. There is no way to avoid the potential drag of bonds unless you simply avoid them. Bonds have less volatility than stocks, but in our opinion lower volatility than stocks is not enough to justify owning an asset class with little potential for future returns.
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