How far should your portfolio lean into higher rates?
Investors have been forecasting the demise of the fixed-income asset class for decades. Extraordinarily low nominal yields have constrained forecasted returns from bonds. Market participants have been waiting for rates to normalize higher for forty years, yet the long-term downward trend has persisted. Many professional investors lack the experience of investing through a rising rate environment. And yet, despite their lack of real-world experience, it is currently one of their highest conviction calls. A simple Google search of “60/40 portfolio” produces headlines that include:
- “The End of the 60/40 Portfolio,”
- “R.I.P. 60-40 Portfolio”, and
- “Traditional 60/40 Portfolio has actually reached its expiration date.”
We have seen this act before. A similar search of 2013 articles yielded equally dour headlines, including terms like “doomed to fail” and “dangers in diversification.” Mark Twain might say, reports of fixed income’s death are greatly exaggerated. Despite persistent headlines of its diminishing role in portfolios, the asset class has continued to deliver steady, diversifying income to investors. Over the last decade, treasuries and high-quality bonds have outperformed cash by a wide margin despite then record-low yields. Where is the disconnect?
Source: The Colony Group
The theoretical arguments that bond bears are making today are as well-reasoned as they were in 2013. A bond portfolio’s primary objective is to generate a stable income stream that is higher than the rate of inflation. When yields are below anticipated inflation, bonds’ utility is diminished. Similarly, investors relying on the asset class for its diversification benefits are questioning this role as yield moves have driven bouts of equity volatility.
Nevertheless, as many academics turned practitioners can profess, theory often translates poorly into practice. In the footnotes of nearly every economic paper and textbook lies a simple Latin phrase that absolves the author of responsibility: “ceteris paribus.” Translated, it means “other things equal.” In the real world, conditions are never truly equal. Economic and non-economic events regularly clash, causing uncertainty and often impelling investors to de-risk their portfolios by allocating into high-quality, liquid instruments. The touchstone of these are U.S. Treasury Bonds. Investors flocked to them during the Dot.com bubble, Great Financial crisis, COVID crisis, and every mini-crisis in between. Those who maintained their long-term, strategic allocations to bonds experienced less volatility (and likely higher returns) than those that desperately tried to rebuild their positions. For investors seeking stability, the fixed-income asset class has remained a valuable source of risk reduction, no matter the level of starting interest rates.
How should investors balance theory with practice? We recommend taking a lesson from the sailing community to gauge how far to lean into any particular idea or trade. The keys to efficient sailing, as well as investing, are speed, balance, and control. That is why, for example, as the boat heels starboard, the captain positions her crew along the edge of the port side. Using her crew as ballast, she controls the boat (and prevents the sailors from falling overboard!). In our portfolios, we are positioning our sails for the winds of change, leaning into unconventional sources of stable returns. To avoid the boat tipping too far, we continue to hold liquid, high-quality bonds.