Bond Volatility Has Blown The Safety Valve In The 60/40 Portfolio

This year's largest fluctuations in bond prices in more than a decade pose a new challenge to the time-honored 60/40 investing approach.

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Portfolios with 60% in equities and 40% in bonds, which have been regarded as stable for decades, lost 17% last year, the worst result since 2008. While such a dismal result is unlikely to be repeated this year, some big Wall Street names are advising investors to seek alternative diversification due to the volatility in debt markets.

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"We are keen to diversify our stabilizing layer so that we are not overly reliant on government bonds," said Catherine Doyle, a real return strategy investment expert at Newton Investment Management. "Recent bond volatility makes it less appealing for 60/40 portfolios."

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The 60% allocation to stocks is meant to produce capital appreciation, while the 40% allocation to bonds serves as a safety valve against stock risk. To work, the correlation between the two assets should ideally be negative, and bond volatility should be minimal — or at least lower than that of equities. Both hypotheses are being tested.

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While bond markets have calmed down a little after the collapse of three US banks in March, there is still plenty of uncertainty ahead that could reignite the turbulence. Sticky inflation means that central banks may not be able to suspend rate rises as fast as predicted, heightening the possibility of a recession or more business failures like Silicon Valley Bank and Credit Suisse Group AG.

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According to BlackRock Inc., 60/40 doesn't work in an environment where central banks are expected to hike interest rates into a recession to reduce inflation. Recent data has verified that anxiety, with US inflation accelerating as growth stagnated, and the eurozone presenting a similar pattern.

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After falling over 40% since a 15-year peak in mid-March, the ICE BofA MOVE Index, which gauges projected movements in Treasuries, has begun to rise again. In contrast, the VIX Index, the most widely used measure of stock volatility, is approaching a one-year low.

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"Bond volatility was abnormally high in 2022 and 2023, which may have implications for bond weightings in risk parity — they may not be as high as before," said Caroline Houdril, a multi-asset portfolio manager at Schroders Plc.

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When inflation is as strong as it is now, equity-bond correlations seldom remain negative for long, cautions Christian Mueller-Glissmann, head of the asset allocation strategy at Goldman Sachs Group Inc. Bond yields, while improving, remain relatively low in comparison to prior inflationary bear markets, such as those in the 1970s and 1980s, when bond prices fell despite stock plunging, he added.

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"We believe the bond buffer will remain smaller and less reliable," Mueller-Glissmann added. "We would look into alternative risk-mitigation strategies in multi-asset portfolios."

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Last year, the 60/40 strategy suffered because bonds and stocks fell in lockstep as central banks raised interest rates. Low bond rates at the time also provided little portfolio protection. Despite the recent setback, there are still plenty of 60/40 believers in the long run.

Matt Bartolini, head of SPDR Americas Research at State Street Global Advisors, stated that fixed income continues to serve three crucial functions in his portfolio: income, diversity, and stability.

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"Volatility is only one component of overall portfolio risk," Bartolini explained. "If their correlations are slightly negative or even low 10%, low single-digit positive, volatility — even if it is elevated for fixed income — could still be a diversifier."

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With the possibility of greater volatility in the coming months due to persistent market stress tied to banks and a focus on whether the US would breach its debt ceiling, some investors are considering alternatives to bonds.

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In this economic situation, gold, according to Newton's Doyle, is a strong hedge. Pim van Vliet, the chief quant strategist at Robeco, agreed, saying low-volatility gold had a place in defensive portfolios.

"People seek low volatility to protect their capital." Bonds have been viewed as an important stock risk diversifier, but they did not prove to be a haven last year," van Vliet said. "While the negative correlation has returned, it is unclear how long it will last."

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