Well-heeled investors had been waiting for the proverbial ‘other shoe to drop’ on bonds for the last decade amid historically low interest rates and yields.
Of course, that ‘other shoe’ certainly did fall with a big thump in 2022 as soaring inflation forced the U.S. Federal Reserve, the Bank of Canada and other central banks around the world to hike interest rates at an unprecedented pace, crushing not just the fixed income allocation in portfolios.
It led to a rout in stocks, too.
In particular, balanced portfolios – the most popular being those allocating 60 per cent of capital to stocks and 40 per cent to bonds, ‘60-40′ for short – took a thorough drubbing.
“What was so different about 2022 is it wasn’t an equity-led selloff; it was a bond-led selloff,” says Chris Heakes, portfolio manager and director of BMO Asset Management, which runs the LSEG Lipper Fund Award winning BMO World Bond Fund - Series F for the global fixed income category.
It was indeed a unique time because typically when stocks dive on bad economic data – and soaring inflation is indeed bad financial news – bonds are a portfolio’s counterbalance. In short, their values typically rise as equity values fall.
But not last year, as bonds’ Achilles heel was exposed by fast rising rates, cutting their value by double-digit percentages in many cases.
“Even before that, the [negative] correlation had broken down” between stocks and bonds in the 60-40 portfolio, widely considered the ideal default allocation for the average portfolio, says David Tulk, portfolio manager with Fidelity’s Global Income Portfolio - Series F, winner of 2023 Lipper Award for global fixed income balanced.
“But no one was really upset when bonds and stocks went up in tandem.”
Yet today, after one of the worst bear markets for bonds in history, investors might be wondering if the 60-40 portfolio is broken for good.
It’s not, says Florence Narine, head of Investment Solutions at IG Wealth Management.
But exactly how it should be constructed has changed.
“The 60-40 portfolio still works for some investors,” says Ms. Narine, who oversees many strategies, including the IG Core Portfolio – Income - Series F, recipient of the Lipper Award for Canadian short-term fixed income this year.
“But it requires more nuanced construction,” especially with respect to bonds, she explains.
“That bond allocation must be more diversified, with different durations, credit quality and geography to mitigate that roller-coaster that comes with equity market volatility,” she says, adding this approach also mutes risks of rising interest rates.
Certainly, money managers saw the risks of the last decade and had long been strategizing to mitigate the impact of rising interest rates by shortening bond durations.
They’re still mitigating risks today, even though those red flags of the past are much less impactful than even a year ago, says Geof Marshall, co-fund manager for the CI Global Core Plus Bond Fund - Series P, a Lipper Award for Canadian fixed income.
“The 60-40 portfolio is down this year too on a global basis, and it would be worse, if not for the equity side being propped up by U.S. stocks, particularly the ‘magnificent seven,’” he says about the seven big technology companies, which includes processor chipmaker NVIDIA Corp. (NVDA-Q) and Microsoft Corp. (MSFT-Q).
Yet today, bond yields exceed four per cent, and fixed income has largely recaptured its stabilizing role in a 60-40 portfolio, he adds.
“As well, real yields – nominal yields minus inflation – are positive, and they have not been positive for some time,” Mr. Marshall says.
That’s good news for investors, particularly retirees, whose portfolios often have more conservative allocations, such as 35-per-cent equities and 65-per-cent bonds, says Joe Wong, senior portfolio manager at ATB Investment Management Inc. for the Compass Conservative Balanced Portfolio - series F1, the Lipper Award winner for Canadian fixed income balanced.
“It’s a great time to be looking to add bonds because the yields are much more attractive than two years ago.”
That does not mean bonds have no downside risk. Inflation may trend higher than expected, and interest rates could rise even higher, he adds.
Yet the consensus among award-winning money managers like Mr. Wong is that the lion’s share of interest rate hikes are done.
Rather, central banks are more likely to cut interest rates in the coming year, which would benefit bond values, particularly those with longer durations, which are more sensitive to interest rate changes, he says.
“Higher yields and increased duration can position portfolios well for gains when interest rates fall.”
Nonetheless, the 60-40 portfolio – while it looks better today than two years ago – is likely never to be the same. Investors not only require a more diversified global strategy that includes government, investment-grade corporate and high-yield corporate bonds, Ms. Narine says; their portfolios should now carve out space for alternative assets like gold, commodities, and private debt and equity.
“These non-correlated assets have shown they can diversify away risks,” providing more stability in environments like 2022, she adds.
Data from Morningstar supports this argument, finding alternative strategies on the whole were largely flat last year versus the U.S. bond market being down about 13 per cent.
Still, 2022 did have a “silver lining” for bonds and the 60-40 portfolio, Mr. Heakes says. With yields higher, outpacing inflation, fixed income not only provides a real return; it will likely be the traditional counterbalance that will rise in value should equity markets fall.
That doesn’t mean, however, that plain-vanilla, 60-40 portfolio is back, Mr. Tulk says.
“That passive 60-40 approach worked when the correlation between stocks and bonds was reliably negative, but that world is largely gone,” he says.
“Today, you have to be a lot more thoughtful about how to construct a portfolio.”