Bond turmoil heralds end of the standard portfolio
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Bonds are supposed to be boring. When they are not, you should pay attention. That makes this week a good time to do just that. Bond yields are on the up: on Thursday the 10-year US Treasury yield hit 1.6 per cent.
That might not sound like much — and it is very low by historical standards — but it has tripled since the summer, with much of the action happening in the last few days.
It’s also not the direction we are used to bond yields moving in: for the past 40 years they have mostly gone down. And perhaps more pertinently, they have almost always gone down — and hence bond prices have gone up — when equities have been struggling — think 1998, 2001 and 2008.
They are now rising sharply, yet equities are falling — the S&P 500 was down 2.45 per cent on Thursday alone. This matters for all sorts of reasons. But for the ordinary investor it should be taken as a hint that a major change is on the way, one that should change the core assumption at the heart of almost all portfolio construction for the past 40 years — the idea that the perfectly balanced portfolio is made up of 60 per cent equities and 40 per cent bonds.
The story goes like this. You know equities are the best asset to be in over the long term. But you also know that equities are prone to regular episodes of boom and bust. You can’t know in advance which type of episode the market will be in when you need your money back — so unless you plan to invest for perpetuity, you need something to steady your ship. So you add in government bonds. These give you a nice feeling of security — you will almost certainly get your money back — and an income too.
You might chop and change your proportions a bit based on your age — more equities for the young, more bonds for the old. But all in all, ask any old-fashioned independent financial adviser how to allocate your money and the odds are that he or she will pop you right into the industry default — the “balanced” 60/40 portfolio.
They’d have been right to do so. Bonds have not only mostly done well in themselves — due to falling interest rates and low inflation — but have also offered protection when equities have been tricky. Between 1970 and now, the standard deviation of a pure equity portfolio has been significantly higher than that of a 60/40 portfolio, meaning that it’s been much more volatile. Yet sitting through the trauma of the ups and downs only in equities would have brought little extra in the way of returns over a 60/40 portfolio.
This is why the Vanguard LifeStrategy 60 per cent Equity Fund has a full £9.6bn under management and why anyone concentrating on their pension will find they have something similar — and why their provider will be shifting their portfolio more into bonds as they age. History tells us it is the best way to invest. Or at least that it once was.
Here’s the problem: given what we are seeing this week, can we be sure that bonds are still a good way to protect our portfolios in times of stress? Are they still “anti fragile”? Look at the past year and you will see this is not the first time they have let anyone in a 60/40 down.
Bonds rallied as equities started to fall in February, but then last March, as equity markets collapsed, bonds did too — and while equities then bounced the returns from bonds did not. The problem here is a simple one: the protection you get from bonds comes from yields falling (and hence prices rising) in the bad times. But yields can only fall so far. If they are already close to zero or negative they don’t have far to fall — and hence don’t not much ability to protect you.
Investors are used to seeing one of two happy things happen in their bond portfolios, says Henry Maxey, chief investment officer at Ruffer, an asset manager. Either they make a nice return on the interest rate or they make that return and more as rates drop and the capital value of their bond portfolio rises. Today’s low rates “challenge the whole thing”: any rise in rates could lose you a lot of money, but at the same time there is very little capacity for them to fall and make you any.
It’s also worth looking beyond recent history as a reminder that we can get false ideas stuck in our heads about the long-term characteristics of various asset classes. In the inflation-plagued 1970s, bonds were more known for “return-free risk” than anything else and of course between 1970 and 1975 a 60/40 portfolio would have lost you 60 per cent of the real value of your money. You might have got your money back on bonds held to maturity but what use is that when its real value has collapsed? More fragile than anti-fragile.
The 60/40 portfolio is not quite dead yet. The moves of the past few days could easily be reversed as monetary authorities, wary of allowing market upsets to derail recovery, intervene to bring rates back down — and bond prices back up. Société Générale’s global strategist Albert Edwards notes that the Reserve Bank of Australia has “already run up the white flag” and is buying more bonds. But even if the great bond bull market is not completely over, the simple reality is that it has to be near its end. Ten-year yields are more than 1.5 per cent in the US, 0.8 per cent in the UK and -0.25 per cent in the eurozone. By any historical standard those rates are rock bottom.
And they are particularly low given the massive fiscal stimulus from governments around the world, the huge gross domestic product growth expected this year (investment bank Jefferies has just upgraded its 2021 forecast for the US this year to an emerging-markets style figure of 6.9 per cent) and the commitments from central banks to ignore inflation in favour of employment targets.
Inflation isn’t great for equities — although over time good companies should be able to raise their prices to match the generalised price rise. However, it is genuinely horrible for bonds — what’s the point in holding something that guarantees you won’t get your money back in inflation-adjusted terms? The upshot is that it is hard to see the thing that has worked so well for the past 40 years working well for the next 40. Anyone still tied to old-fashioned defaults should perhaps be looking for new forms of protection. A little gold, more cash than usual and an equity portfolio shifted towards value are all good places to start.
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