Tuesday, March 15, 2022
With most equity and fixed income markets down to start the year, a traditional 60/40 portfolio has come under pressure. Moreover, seeing both markets down simultaneously may cause investors to question the validity of a 60/40 portfolio broadly and core bonds specifically. For us, the value proposition for core bonds is that they tend to provide liquidity, diversification (to equity market risk), and positive total returns to portfolios. Unfortunately, none of those values are 100% certain all the time. Like all markets, fixed income investing involves risks and at times, negative returns (although negative fixed income returns tend to be much smaller than negative equity returns). That said, as painful a start to the year as it has been for equity and core fixed income investors, it isn’t all that uncommon to experience negative returns for both equity and fixed income markets at the same time. In fact, since 1995, nearly 15% of monthly returns have had both negative equity and fixed income returns. Again, it doesn’t make the experiences of a diversified portfolio any less painful this year but it also doesn’t change, in our view, the argument to own core bonds in a portfolio.
“It has certainly been a rough start to the year for core fixed income investors,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “But higher yields mean there is now an opportunity to invest at better valuations, which may mean future returns for bonds have likely improved. The ‘buy the dip’ mentality works for fixed income investors as well.”
Core bonds, and more specifically, U.S.Treasury securities continue to be the best diversifier to broad-based equity market sell-offs, which tend to happen when the economy slows or there are macroeconomic shocks. The LPL Chart of the Day shows the monthly returns of the S&P 500 index in months it was down at least 3% versus Treasury index returns during the same months. When we look at how Treasury securities have performed during periods of equity market selloffs, we can see that Treasury security returns have been mostly positive—although not every time. But in every situation, Treasury securities outperformed equities, which means an allocation to Treasury securities would have both improved portfolio returns and reduced portfolio volatility.
The big story this week is the Fed will likely start a series of short-term interest rate hikes to try and arrest stubbornly high consumer price increases. This shift in monetary policy (from accommodative to less accommodative) adds risks to the economic recovery. And while we don’t think the U.S. economy is headed into a recession over the next 12 months, recessionary risks are increasing (albeit from very low levels). Moreover, when you consider that broad macro shocks happen periodically and, unfortunately, often without warning, it makes it incredibly difficult to know when to own Treasury securities. So we think it’s best to have that potential portfolio protection in place before it’s needed.
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All index and market data from FactSet and MarketWatch.
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