Can bonds once again play a bigger role as part of a well-diversified portfolio?
- We believe investors may be better served by a more flexible approach to diversification instead of being rigidly constrained by a fixed equity/bond structure.
- The experiences of 2022 highlight the benefits of being flexible and looking forward rather than extrapolating the past.
- However, if a 60/40 portfolio can be re-evaluated and evolve, there may still be life in it yet.
Much has been written about the death of the 60/40 portfolio, particularly as bond yields reached all-time lows and the potential for meaningful returns from the asset class appeared limited. We maintain that investors may be better served by a more flexible approach to diversification instead of being rigidly constrained by a fixed equity/bond structure. However, 2022 has seen one of worst bond market sell-offs in a generation after central banks aggressively raised interest rates to contain inflation, leading to the unwinding of what was probably the world’s most controlled and crowded trade. Against this backdrop, adding bonds back into your portfolio mix, or at least not throwing the baby out with the bath water, could now be an appropriate response.
Just over a year ago, in the summer of 2021, 10-year UK government bonds yielded less than 1%, with 10-year US Treasuries not much better at between 1-1.5%, a level that was little more than half the inflation target of the world’s most important central bank. This was at a time when supposedly transitory inflation, at 5.4%, was already running at more than twice the US Federal Reserve’s target level.
Today, central banks across the world are of the view that they need to bring inflation under control, and 10-year government bond yields are hovering at around 4% in the US and UK, double their central bank inflation targets. The Bloomberg Global Aggregate Bond Index is down c. 14.3% year to date and the UK government bond market, being longer duration, is down c. 26% year to date, nearly on par with the tech-heavy Nasdaq Index, which is meant to represent far riskier assets. In fact, according to Bank of America Global Research, global government bonds are on course for their worst year since 1949.
We have long been warning that risk is not just about specific asset classes, nor is it about volatility. Risk can and does manifest itself in various manners: market risk, duration risk, inflation risk and political risk are just a few of the risks that have reared their heads this year. For this reason, it is important to consider risk and return together, alongside an appropriate time frame, as it is ultimately returns that investors are concerned about. Cautious investors, who may be more focused on not losing money, may have lost more than expected this year, given their generally higher allocations to bonds. Unfortunately, far too many have looked at bonds as being low risk, rather than considering risk and return in combination.
Nevertheless, after the huge bond market sell-offs seen this year, the asset class could be set to fare better, and it is worth mentioning that since 1976 investors have never experienced a three-year negative return on both equities and bonds at the same time.
While policymakers are likely to continue to increase interest rates to bring inflation back down to target, the effect of this will vary across the yield curve. Further rate increases may push yields higher at the shorter end, but the effect might be less at the longer end (such as 10-year or 20-year maturity bonds) as the market starts to price in the impact on the economy and any likely recession, given 10-year US Treasury yields are now at their highest level since before the 2008 global financial crisis.
In summary, we believe bonds are buyable again, both in terms of their potential to generate returns and for diversification purposes. In our view, they should once again play a bigger role as part of a well-diversified portfolio, although we would add real assets to the mix to help protect against inflation being more persistent than expected. The experiences of this year should highlight the benefits of being flexible and looking forward rather than extrapolating the past. If a 60/40 portfolio can be re-evaluated and evolve, there may still be life in it yet.
 Source: FactSet, 21 October, 2022
 Source: MarketWatch, ‘The worst year in U.S. history for the 60/40 portfolio’, 19 September 2022
 Source: Reuters, ‘Bond sell-off worst since 1949, Bank of America says’, 23 September 2022
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