Bonds and the illusion of diversification
2022 has brought us to a historic turning point in financial markets. A fundamental investment strategy that has protected institutional and retail investors alike for decades – balancing equity risk by holding high-quality bonds – broke down in spectacular fashion. For the past 20 years, equities and government bonds were reliably negatively correlated; bonds would rise in value when equity markets dropped, reducing the downside risk of the overall portfolio. When central Banks started raising interest rates to combat inflation, equity and bond markets fell in tandem, leaving millions of investors largely defenseless as bonds no longer acted as an insurance policy.
As central banks have started raising interest rates, the yield component of bonds has returned. From a nominal perspective, bonds once again provide an (attractive) source of return. However, the expected diversification effect from an investment in bonds seems less reliable, now the correlation ration between equities and bonds is positive.
For bonds to act as a reliable portfolio diversifier, the correlation between bonds and equities have to be negative. Meaning bonds will rise in value when equities drop.
We have entered a macroeconomic world driven largely by non-traditional supply shocks, including a tight labor market, rising geopolitical tensions on multiple fronts and a global energy transition. A period of higher inflation, higher borrowing costs, tightening lending standards and reduced government spending will most likely hurt economic growth and the return outlook for equities.
This changed investment landscape, warrants a different approach to portfolio construction, including a rethink of the merits of the traditional “60/40” portfolio. The reliable relationship between equities and bonds, particularly during volatile markets, is changing. If we are faced with another crisis will bonds deliver a positive return to offset losses from falling equities?
Probably not. Central banks have made it clear that bringing down inflation is their number one priority. Although inflation has come down in recent months, inflation still sits well above target. Making it very unlikely central banks will lower interest rates to support economic growth.
That leaves the interest on your bond holdings as the only reliable source of return. For bonds to act as a portfolio diversifier, bond prices have to rise and interest rates have to come down in times of market or economic stress. This relationship, the foundation under the diversification strategy of the “60/40” portfolio, is broken.
Faced with this illusion of diversification, advocating a traditional “60/40” portfolio like this in the new investment environment we are facing seems unfair and irresponsible. Doing so leaves investors seriously exposed to downturns. With the diversifying power of bonds broken, there is no longer any natural choice. This inevitably means we should expect lower forward returns from balanced portfolios, because bonds may no longer serve as a shock absorber.
In seeking new sources of uncorrelated and assymetric returns for balanced portfolios, asset allocators will have to think about alternatives to equities and bonds. Including gold, private equity, private credit, specific hedge fund strategies and explicit volatility strategies – directly hedging equities.
Alternatives play a critical role in risk mitigation and diversification. Compared to traditional investments as equities and bonds, alternative strategies can generate different performance profiles, increasing the potential for uncorrelated sources of return. Hereby increasing the potential to not only deliver better returns but also reduce portfolio risk across most macroeconomic environments.
Without alternatives like private equity, private debt and hedge funds, many investors are working with an incomplete toolkit as they navigate a tricky investment landscape. Mainly US institutional investors like pension funds, insurance companies and endowment funds have made alternatives a core portfolio component, more than doubling their allocations in the last decade. For one important reason: the potential for long-term outperformance.
Just as pensions must grow and manage payouts through good markets and bad, individual investors need their portfolio to weather volatility, compound wealth and fund specific goals like paying for a child’s education and providing retirement income.
With higher interest rates for longer and a challenging macro economic outlook, investors are facing lower forward returns and portfolios skewed towards equity risk. This is not the time to fall back on or hold on to a portfolio that has worked so well for so long. This time is different, and what worked so well in the past is by any means no guarantee for the future. To optimize portfolio risk and returns, a broader allocation toward alternative investments must be considered.
Savin Investment Partners