The writer is a managing director and portfolio manager at Pimco
Is a traditional portfolio of 60 per cent in equities and 40 per cent in bonds obsolete? Many investors thought so this year. However, the strategy has so far defied forecasts of its demise.
Despite concerns that the secular bull market for interest rates is ending, a closely watched benchmark* for the 60/40 strategy delivered a return of 11 per cent in 2020 up to December 15. That followed three decades of annualised returns of 7.6 per cent.
No doubt the new year will bring more questioning of the 60/40 strategy and, in particular, whether bonds offer an effective complement to riskier asset classes such as equities.
Returns over the horizon may be harder to achieve, but bonds will still play a very important role in portfolios. Indeed, the traditional benefits of bonds — diversification and a moderation of portfolio volatility — could be especially beneficial in the years ahead. The global economy is likely to see a bumpy recovery and broader shifts that could create much greater volatility than the market has experienced over the past decade.
The yields of fixed-income assets have also boosted the returns of multi-asset portfolios over the years. The benchmark US Treasuries delivered a fixed, reliable yield that has averaged 4 per cent over the past three decades.
In fact, 2.3 percentage points 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, steadying the ship for investors during periods of volatility in riskier portions of the portfolio.
While equities over the past three decades have returned 8.8 per cent per year, the volatility of the asset class has been high. In that time, there have been three periods of drawdowns when the market, as measured by the MSCI All Countries World Index, fell more than 30 per cent. 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 has been largely negative, meaning that when stocks have fallen, bonds have typically risen.
These historical relationships between stocks and bonds, however, are under stress in today’s low, or some cases negative, interest rate world. The “haven” status of bonds during volatile periods was stress-tested in the market turmoil in the first quarter of the year as the world went into lockdown.
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’s 10-year Bund, yields started 2020 already slightly negative and then plunged to a record low of -0.86 per cent during the Covid-related volatility in the first quarter. Moreover, US Treasuries continued to return a positive nominal return, but yield on the 10-year note dropped as low as 0.51 per cent this year.
In the years ahead, market volatility is likely to be higher than over the past 10 years, particularly as monetary and fiscal accommodation wanes and inflation gradually rises. The world also faces potential political destabilisation from populism and an unwinding of trade globalisation.
Moreover, economic and market disruption brought about by technological change and demographic shifts will lead to extreme events 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.
However, investors are finding that they must target specific regions and parts of the yield curve in order to maximise return and diversification potential.
Massive intervention by central banks to keep interest rates down, coupled with risk aversion in response to Covid-19, have forced developed market sovereign bond yields to even lower levels.
There are opportunities, though, in high-quality assets such as mortgage-backed securities from US government agencies that are receiving support from the US Federal Reserve. Other attractive areas are AA and AAA rated investment-grade corporate bonds and emerging market debt that is currency hedged.
One answer for 60/40 portfolio investors is to divide fixed-income investments into two subcomponents — hedging and yield assets. By doing so, investors can create a well-diversified fixed-income portfolio that can still provide tremendous benefit to multi-asset portfolios.
* The benchmark is 60 per cent based on the MSCI All Country World Index Total Return ($ unhedged) and 40 per cent the Bloomberg Barclays Global Aggregate Index ($ hedged)
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