June 25, 2020 glacierinvest

We discussed the danger of dogmatic investing last week. One of the investing dogmas of the past 30 years or so is the 60/40 portfolio as the go to portfolio for the masses. The portfolio is constructed of 60% stocks and 40% bonds and is designed to grow, via stocks, during an up-market and to help preserve capital, via bonds, during a down market. It’s worked rather splendidly over the past three decades as bonds have tended to zag when stocks have zigged. There have even been periods over the past decade where both have increased together while still affording investors some downside protection (the best of both worlds!).

Conventional Wisdom

As COVID-19 took hold this year and the stock market hit the skids, bonds did their part, holding steady during the stock market sell-off. We’ve all been conditioned to believe that bonds go up when stocks go down and vice versa. The direction of interest rates drives bond prices. When stocks are going up, the economy is presumably growing and interest rates should be rising causing bond prices to decline. When economic weakness sets in and stocks begin to decline interest rates generally fall as well causing bond prices to increase. It’s a virtuous cycle that has been very effective over the past 30 years.

The trouble with all of this is we’ve been in a massive downtrend in rates capped by an abnormal monetary and rate environment for the past ten years with a lot of monetary intervention in the form of quantitative easing and quantitative tightening. For the most part, bonds have been on a one way ticket up as yields have been declining since peaking in the early 1980’s. Today, the 10-year US Treasury yield is lower than it was at the depths of the financial crisis and isn’t too far off its recent all-time lows, at least dating back to 1871. This isn’t to say that rates can’t go lower. We know negative rates are possible as we’ve seen in other parts of the world. However, banking on negative rates as your hedge thesis for bonds doesn’t seem prudent to me. Even if rates do go negative, they would have to go substantially negative, based on where yields are currently, in order for bonds to provide the same level of downside protection they’ve historically provided. The current risk-reward proposition is not very favorable, in my opinion.

Rethinking Your Bond Allocation

While it might seem counterintuitive given the amount of risk there appears to be in the system, at least considering reducing your bond exposure here may be a good idea. I’m not implying you reduce your bond allocation only to increase your stock exposure. Other less correlated return streams do exist and can offer diversification benefits. They may not appreciate like bonds have done over the past several years but they can help to preserve capital for future growth compounding.