With 2022 in the rear-view mirror, most investors are likely aware that last year represented the worst year for U.S. Treasuries on record, falling 12.5 per cent in aggregate based on Bloomberg data back to 1974.
Despite what some are saying, we disagree with any notion that the strategy of holding a 60/40 asset mix is dead. In fact, our work shows that having bond exposure provides superior risk-adjusted returns over time. (That is revealed in a higher Sharpe ratio, an indicator that measures return relative to overall risk).
The investing landscape in 2022 was unique, with the ultralow starting point for the bond yield and uber-inflated multiples in the stock market. These have at least partially been resolved in last year’s dual bear phases.
What we found in our analysis is that a portfolio made up of 60 per cent stocks and 40 per cent bonds may not even be the most appropriate benchmark asset mix – a blend of 50 per cent equities and 50 per cent Treasuries scored better in terms of delivering risk-adjusted total returns.
To suggest abandoning a 60/40 (or 50/50) strategy is to say diversification is out of style – but diversification never really goes out of style. It remains a prudent risk-management tool, notwithstanding the reality that overall expected returns are far lower today than they have been historically.
When looking at some of the reasons behind the down-year for Treasuries, there were a number of factors at play. There was a palpable distaste for bonds as 2022 began – sentiment was decisively bearish, and investors were shedding positions at seemingly every opportunity. Inflationary pressures were building as supply-chain bottlenecks that presented themselves from the pandemic were exacerbated by the Russia/Ukraine war. All eyes were on the Fed to react as it was increasingly viewed as being behind the curve; it responded by unleashing the fastest rate-hiking cycle since the 1980s.
That said, the reasons behind the move in bond markets are to be viewed as more idiosyncratic than the beginning of a new era when it comes to inflation and the Treasury market. Already we are seeing supporting signals of this in many survey-based measures of inflation expectations, alongside other signs of cooling price pressures. In short, the primary reason behind the 12.5-per-cent decline for the Treasury market in 2022 is heading in reverse.
The economic backdrop and market conditions affecting the Treasury market will normalize going forward and there are benefits to continuing to hold Treasuries in one’s portfolio. First, when compared with equity-market valuations, they are more attractive on a relative basis. For example, the equity risk premium (which measures how much extra compensation investors are obtaining relative to bonds for the extra risk) is at levels last seen in 2007.
Additionally, given the prior run-up in interest rates, coupon payments on newly issued Treasuries have risen accordingly. Indeed, while the coupon on the 10-year and 30-year was 1.375 per cent and 1.875 per cent, respectively, prior to the sell-off in 2022, the most recent issue for each maturity pays 4.125 per cent and 4.000 per cent, respectively – two times to three times higher and offering more of a cushion against potential price declines should the Fed keep interest rates at elevated levels, as it says it intends to do.
The fact is that successful investors do not just focus on potential returns, but also the need to protect capital and manage their downside risk. The simplest way to evaluate a portfolio on this basis is to look at risk-adjusted returns (the Sharpe ratio). How much excess returns (over and above the risk-free rate, which we defined as short-term Treasuries) is a portfolio generating per unit of volatility? The higher the number, the better the result on this front.
We wanted to demonstrate how adding Treasuries to the asset mix can improve the risk-adjusted return, thus showing how bonds can be a ballast in the portfolio. To do so, we looked at annualized excess returns from the past five, 10, 20, and 30 years of a simple mix of 100 per cent stocks, 90 per cent stocks/10 per cent Treasuries, 80/20, 70/30, 60/40, 50/50 and divided each by their respective volatilities over the same timeframe. Take a look at the accompanying table for the results.
Historically, when Treasuries are added to a portfolio in any meaningful amount (40 per cent or more), there is a notable uptick in Sharpe ratios – particularly over longer time horizons of 20 years or more, which smooth out this most recent hiccup.
Ultimately, a portfolio heavily weighted toward stocks will obviously have a better return, but it actually performs worse in its Sharpe ratio over the long term compared to when more Treasuries are added to the mix. This is the basic trade-off investors need to make – balancing risk versus reward, depending on their personal financial situation and investment horizon.
While 2022 unfortunately resulted in a breakdown of the stock-bond relationship, as mentioned previously there are reasons to believe that this was a unique year and not the beginning of a new era.
Despite the popular narrative, bonds are not dead – they have an appropriate long-term place in the portfolio from a risk perspective.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Marius Jongstra is senior economist and strategist with the firm.
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