One of the biggest concerns on Wall Street these days is the fact that bonds are no longer providing diversification for stocks.
Bonds no longer provide a hedge
For the past 40 years, one of the easiest and best ways for investors to dampen volatility and achieve return was to simply construct a 60/40 portfolio of stocks and bonds. In fact, investment advisors who put their clients into this simple mix outperformed almost every other strategy with far less risk.
The principal reason for the 60/40 mix is that during times of turmoil when equities declined sharply, investors flocked to bonds so some of the losses in stocks were offset by gains in bonds.
In times of growth, however, when equities rose sharply, bonds did not sell off, so they offered the best of both worlds—a hedge when stocks declined and no drag when stocks rose.
This formula has worked so well for generations that many investors have been lulled into thinking that this is the natural order of things and that a 60/40 portfolio will always be the best way to allocate assets.
In fact, the multi-generational success of this approach is nothing more than a historical anomaly. The reason why this strategy has worked has far more to do with a multi-decade decline in yields rather than anything else.
The success of 60/40 portfolio is a historical anomaly
During the inflationary 1970’s and early 1980’s, US Treasury yields reached an all time high of 15.82% in 1981. For the past 40 years, yields have been steadily decreasing until they hit an all time low of just 52 basis points in July of 2020.
This massive super cycle has likely come to an end and will wreak havoc with many established strategies that were tailor made for the prior environment.
Note the massive 12.1 Billion dollar loss suffered by Bridgewater Associates—still the most profitable hedge fund of all time—but one that may be well past its prime if it continues to rely on its strategy of levering up returns on bonds which are unlikely to provide any meaningful gains in the foreseeable future.
Inflation is the reason why bonds are no longer a strong safe haven asset. Even if the current inflationary problems are transitory and will eventually ease as supply chains are restored, the near term environment for investors will be toxic.
What matters to fixed income investors is not the absolute rate of return, but rather the real yield on assets (nominal treasury yields minus inflation) and real yields on bonds will continue to fall—certainly for the foreseeable future as base effects continue to ratchet up inflation reading while the Fed continues to suppress yields across the curve.
Thus, the flight-to-safety diversification trade, which is the implicit bet of the 60/40 portfolio, will no longer work nearly as well as it did in the past.
What is a better way to protect the portfolio?
If inflation does become an nagging problem for the US economy, then a mix of equities, real assets (such as real estate and commodities) and principal protection assets (such as gold and crypto) will be a much better diversification offset to a 60% holding of stocks.
Stocks generally perform well during inflationary periods, especially if growth can outpace inflation, but they also become far more volatile and allocation to bonds will not protect investors from these sharp declines.
In a period of negative real rates, non-yielding assets such as gold and crypto provide a much better balance to market risk. Crypto is ridiculously volatile but a small allocation to Bitcoin or Ethereum along with a larger proportion to precious metals would provide a blended basket that could offer protection with a more modest amount of volatility than crypto alone.
The crypto/precious metals mix will be easier to enable once the SEC allows for a Bitcoin ETF, but for now investors should reexamine the underlying assumptions of the 60/40 portfolio which may soon become a historical relic.