By Taosha Wang
The past few years haven’t been easy for bond investors, as the “safe haven” asset has struggled in both sunny and cloudy markets. This raises an important question: Is it time to ditch the traditional 60/40 portfolio in favor of something more dynamic?
During 2024, global bonds delivered a paltry total return of -2%, while global equities were up 18%. And in 2022, when global equities recorded an annual loss of 18%, bonds offered little downside protection, falling by 16%.
Bonds’ limited utility in recent years is due to three key factors: correlation, volatility and curvature.
First, bonds help offset portfolio risk when the correlation between bonds and equities is negative. During the five years leading up to March 2020, the height of COVID-related market turmoil, bonds and equities were negatively correlated almost 60% of the time, when calculated on a rolling 120-day basis. Since then, however, equities and bonds have been negatively correlated less than 10% of the time.
Next, fixed income volatility needs to be low in order for bonds to smooth out returns in a diversified portfolio. But average fixed income volatility, as commonly measured by the MOVE index, has almost doubled since 2022 when the Fed started hiking interest rates, and it hasn’t normalized despite recent rate cuts. When bonds are choppier, they can’t easily serve their function as defensive anchors in diversified portfolios.
Given that each of these three factors can move significantly due to changes in growth, inflation, interest rates and other monetary policy actions, the classic strategy of maintaining a static 40% allocation to bonds appears seriously flawed.
Bond investors may want to instead consider taking a more dynamic approach, continually assessing the current environment and shifting their bond allocations accordingly.
FINDING BOND PROXIES
Here is another challenge: Many investors want to use bonds to express their views on the trajectory of interest rates, essentially the cost of money, which obviously plays an important role in driving investment outcomes.
But if bonds’ tepid returns and inconsistent hedging benefits turn off capital allocators, what other strategies are available?
One option is to invest in companies with interest-rate sensitive equity valuations, such as many major technology companies (e.g., Apple, Microsoft and Amazon). These firms habitually generate growth well ahead of the broader economy. A company’s valuation is the sum of all future profits discounted to the present at the applicable discount rate. The higher the expected growth rate, the more sensitive the equity valuation is to changes in discount rates.
Moreover, when interest rates fall during periods of soft economic growth, large tech equities often attract so-called “bottom fishing” investor interest because of their highly defensible business models, relative non-cyclicality, and consistent cash flows.
As a result, these equities have bond-like characteristics, even though they typically generate returns well in excess of what an investor could expect to earn in investment grade credit.
Another way for investors to gain some of the benefits of bonds without capping their upside is by investing in companies whose businesses are interest-rate sensitive.
Banks, for instance, typically profit from higher interest rates and steeper yield curves because they capture the difference, or net interest margin, between sticky short-term deposit rates and market-adjusted long-term lending rates. In contrast, homebuilders benefit from lower interest rates. When borrowing costs are lower, mortgages become more affordable, boosting demand for new housing.
But investing in equities in these industries obviously isn’t just an interest rate play. Investors also gain exposure to fundamental growth drivers in these sectors. For example, an investor in banks could potentially benefit if the incoming U.S. presidential administration supports more accommodative banking regulations, while an investor in homebuilder equities could enjoy capital appreciation due to the chronic undersupply in the U.S. residential housing market.
These additional sources of return mean that, compared to pure bond strategies, investing in the equities of interest-rate sensitive industries can potentially offer a larger margin of error if the interest rate call goes wrong, provided investors have a proper understanding of the particular industry and company.
Investors should thus consider injecting more dynamism into their bond strategies and also questioning whether the best way to access some of the traditional benefits of bonds may by investing in a different asset class altogether.
(The views expressed here are those of the author, a portfolio manager and creator of the “Thematically Thinking” newsletter at Fidelity International.)
(Writing by Taosha Wang; editing by Anna Szymanski)
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