The Problem With Bonds

Summary

• Bonds are underperforming other asset classes this year.
• They struggle to offer adequate downside protection, unbalancing the traditional 60:40 portfolio.
• We would underweight bonds but caution against increasing risk through alternatives.

Bonds Are Struggling Right Now

The traditional 60:40 portfolio once served investors well. A 60% allocation to equities (for capital appreciation) combined with 40% to bonds (for income and risk mitigation) generated an 11.1% annual return over the last decade. And adjusting for inflation, you still got 9.1% – nothing to sniff at.

But bonds in particular, the defensive side of that ratio, are struggling with a multitude of headwinds right now, especially rising inflation. So far this year, emerging market bonds are down 10%. And the US is little better: high yield is down 5%, investment grade is down 8%, and government bonds are down 6%. March has been the worst month for US government bonds since former President Donald Trump was elected.

With a recession possibly in the works, investors holding bonds might need to be worried. Andy Constan, founder of Damped Spring Advisors and former Chief Strategist at Brevan Howard, argues that ‘prices won’t rally as much as they did in past environments when there is an anti-growth shift. A recession in Europe is just not going to rally the bund enough to protect the DAX. Same in Japan. The US is a little better off.’

The pandemic was evidence of that. Treasuries rallied 31% and the Aggregate Index 18% when the internet bubble burst in the late 1990s. But when Covid-19 hit, the former rose just 5%, while the latter dropped 3%. The downside protection seems to have vanished.

The Decline and Fall of the 60:40

The death knell for the traditional 60:40 portfolio has been ringing for some time. Barron’s proclaimed it finished back in November. A recent article by Morningstar hinted it had life in it yet, but that investors ought to ‘tinker’ with the bond side of the equation.

With the strategy facing obsolescence, big names like BlackRock are also calling for a rethink. Bonds, they argue, face low yields, higher inflation and rising rates. And inflation especially will erode real yields even more if it keeps ticking up. As they put it, ‘bonds may not provide the same level of return boost as they have in the past, making stock returns (and the accompanying volatility) an even greater driver of future 60/40 portfolio results.’ But how do you build an all-weather portfolio when bonds are struggling to give you the downside protection and fixed income you need?

Where to Look Instead of Bonds

Bonds in their current condition risk unbalancing a traditional 60:40 portfolio. As Constan explains, ‘It doesn’t have the same expected return for the amount of risk. The expected return can be the same, and it should be, but the amount of risk is changed. And so, there’s a very simple logic to that, take less risk.’

At Macro Hive, we like to be significantly underweight bonds right now. And from a simple survival perspective, cash is king. You will not outperform inflation, but you also will not lose nominal value. And that safety net could keep you in the black.

Another way to diversify is into commodities. Thanks to the energy crisis, inflation and the Russia-Ukraine war, they are outperforming right now – up 39% YTD. We are bullish on uranium especially. It has significant tailwinds including US withdrawal from the Russian market and several countries still clinging to nuclear for their power needs.

Matthew Tibble is Commissioning Editor at Macro Hive. He has worked as an editorial consultant and freelance editor for companies such as RiskThinking.AI, JDI Research, and FutureScape248.