(Bloomberg) The biggest swings in bonds in more than a decade this year are a fresh challenge to the time-honored 60/40 investment strategy.
Holding 60% of portfolios in stocks and 40% in bonds, revered as reliable for decades, fell 17% last year, the worst performance since 2008. While it’s unlikely such a dismal result will be repeated this year, some big Wall Street names are suggesting investors look for alternative diversification given the volatility in debt markets.
“We are keen to diversify our stabilizing layer so that we are not overly reliant on government bonds,” said Catherine Doyle, an investment specialist for real return strategy at Newton Investment Management. “Recent volatility within bonds makes it less attractive for 60/40 portfolios.”
The 60% allocation to stocks is intended to provide capital appreciation while the 40% holding of bonds acts as a safety valve for stock risk. For it to work, ideally the correlation between the two assets should be negative and bond volatility should be low — or at least lower than equities. Both theories are being put to the test.
While bond markets have calmed down a touch after wild swings in March following the collapse of three US banks, there’s plenty of uncertainty ahead that could bring back the turbulence. Sticky inflation means central banks may not be able to pause rate hikes as soon as hoped, raising the risk of recession or further corporate collapses to follow those of Silicon Valley Bank and Credit Suisse Group AG.
BlackRock Inc. said recently that 60/40 doesn’t work in an environment where central banks are likely to raise interest rates into a recession to bring down inflation. Data in recent days has validated that concern, showing US inflation accelerated while growth slowed, while it looks a similar picture in the euro area.
The ICE BofA MOVE Index, which tracks expected swings in Treasuries, has started to pick up again after tumbling by nearly 40% since a 15-year high in mid-March. By contrast, the VIX Index, the most common gauge of stock volatility, is holding near a one-year low.
“Bond volatility was abnormally high in 2022 and 2023 so that might have implication in terms of bond weightings in risk parity — it may not be as high as before,” Caroline Houdril, a multi asset portfolio manager at Schroders Plc.
Equity-bond correlations have seldom stayed negative for long when inflation is as high as right now, warns Christian Mueller-Glissmann, the head of asset allocation strategy at Goldman Sachs Group Inc. Bond yields, while improved, are still relatively low compared to other inflationary bear markets like the ones in 1970s and 1980s when bond prices dropped despite equity falling, he said.
“We think the buffer from bonds is likely to remain smaller and unreliable,” Mueller-Glissmann said. “We would look at alternative risk mitigation strategies in multi-asset portfolios.”
The 60/40 strategy suffered last year because bonds and stocks fell in tandem as central banks raised interest rates. Low bond yields at that time also provided little protection for the portfolio. Yet there are still plenty of 60/40 believers for the long run, despite the recent setback.
Matt Bartolini, head of SPDR Americas Research at State Street Global Advisors, said he still has 40% fixed income in his portfolio as it plays three important roles — income, diversification and stability.
“The volatility is just one component of creating overall portfolio risk,” Bartolini said. “If their correlations are slightly negative or even low 10%, low single-digit positive, that volatility — even though it’s elevated for fixed income — still could be a diversifier.”
With the potential for more volatility in coming months, given lingering market stress linked to banks and a focus on whether the US could break a debt ceiling, some investors are looking at alternative assets to bonds.
Newton’s Doyle sees gold as a solid hedge in this economic environment. That’s a view shared by Pim van Vliet, chief quant strategist at Robeco, who said low-volatility gold has a role to play in defensive portfolios.
“People go for low volatility because they want to protect their capital. Bonds have been seen as a key equity risk diversifier, but it didn’t prove to be a safe haven last year,” said van Vliet. “While the negative correlation is back, it’s not clear how long this will last.”
