by Jeffrey Rosenberg, Sr. Portfolio Manager, Systematic Fixed Income, Blackrock
The outlook for protracted zero interest rate policy with historically low long-term interest rates means fixed income markets offer both lower returns and less equity diversification potential. Together, these pose unique challenges to the traditional 60/40 portfolio. The loss of bond ballast, or the ability for bonds to offset equities in downturns, is an important, but often overlooked, consequence of the Fed’s promise to hold rates at zero for the foreseeable future.
Easy answers entail tough tradeoffs. Increasing exposure to credit may help solve for low levels of yield but comes at the cost of exacerbating the equity diversification problem. Doing nothing at all still results in a riskier overall portfolio of debt and equity, as the sensitivity of rates to falling stocks stands at about half its historical norm.
For investors unwilling or unable to handle the rise in overall portfolio risk, we investigate several potential solutions for solving the fixed income diversification problem. Without action, we may be at risk of investing without a parachute.
What happened to the parachute?
In Part I of Investing Without a Parachute we argued that because both long-term and short-term interest rates were close to their effective lower bounds, or the level where rates are so low that they cannot drop that much further, bonds have lost a significant portion of their potential to diversify equities. This lower bound limits the magnitude that bond prices can appreciate when equity prices drop. This change in prospective fixed income return behavior requires a rethinking of the role of bonds in a traditional 60/40 portfolio.
September 2020: A hard landing
The September 2020 sell-off in equity markets provides the first case study on the potential future of fixed income returns. The month illustrates how different the bond market behaves today relative to how we might have expected based on history—even as recent as the start of the year.
Treasury bond returns over the month were about half of what a similar magnitude equity sell-off would have implied based on the longer run history of rate/equity return relationships. Even though bond yields still fell (the correlation of stock and bond returns is still negative) the strength of that relationship is lower (the beta is lower).
A simple proposition for why the degree of responsiveness is lower is the proximity to the zero-lower bound. Though policy rates in other countries have gone negative, policy makers at the Federal Reserve have repeatedly highlighted their belief that for the US, the effective lower bound of interest rates is zero. So, with less room to fall, interest rates likely respond less to equity market declines going forward.
By our estimates, the beta of 10-year and 30-year US Treasury yields stand at about half of their long-term averages. In the shorter end of the yield curve (less than 5-year maturities), the beta is effectively zero, as these rates already reflect the expectations that the Fed will maintain an extended period of zero interest rates until at least 2023.
Evaluating other possible parachutes: Gold, TIPS, and “bond-like” stocks
An initial response to the loss of ballast from fixed income is to simply look for replacements to fixed income. Gold, TIPS, and defensive “bond-like” stocks frequently come up as alternatives.
All that glitters is…
Gold has a quite variable track record of diversification to equities. Unlike the more reliable negative stock/bond correlation, we have seen many periods of positive stock/gold correlation.
Gold lacks bonds’ reliable diversification properties
Stock/gold and stock/bond 5-year rolling correlation
Source: Bloomberg, as of 10/30/2020. “Stock” represented by the S&P 500 Index. “Gold” represented by the gold spot price. “Bond” represented by the 10-Year US Treasury.
Most worryingly, in larger equity sell offs of more than 5%, gold’s correlation to equities averages a positive 24%—certainly not the hedge investors are expecting. In fact, over the past 6 recessions, gold exhibited strongly negative correlations to equities in only the recessions of 1990 and 2001 (see figure below).
Gold’s diversification potential for stocks during recessions has been mixed
Gold correlation in recessions
Recessionary periodsGold & S&P 500 return correlation
Dec 07 – Jun 09-0.01Mar 01 – Nov 01-0.34Jul 90 – Mar 91-0.47Jul 81 – Nov 82+0.59Jan 80 – Jul 80+0.67Nov 73 – March 75+0.08
Source: Bloomberg, as of 10/30/2020. Recessionary period defined as two quarters of negative GDP growth by the National Bureau of Economic Research (NBER). Gold and S&P 500 return correlation based on historical monthly total returns.
Are we near a TIPSing point?
Today’s era of fiscal monetary coordination raises the possibility of future inflation. We remain more sanguine in the near term to any inflation consequences from the current combination of fiscal and monetary expansion in the face of COVID challenges. However, the prospect of longer-run inflation acceleration raises the interest in TIPS as an additional tool for diversification.
Periods of rising inflation have posed the biggest challenge to the benefits of the 60/40 portfolio. During the past 20 years, the Fed’s success at creating falling inflation had been key to providing those bond diversification benefits. But the market also consistently over-estimated the expected level of inflation relative to realized, adding to bond returns.
However, today’s bond markets offer very different forward-looking perspectives. Today, bond prices reflect expectations for secular stagnation, persistent low inflation and low (and even negative) compensation for inflation term premia (see figure below).
Secular stagnation is now reflected in the term structure of interest rates
5-Year interest rate expectations in 5 years time
Source: Bloomberg, as of 10/30/2020.
The bond market recognizes and agrees that the Fed is fighting inflation from below. That means historical performance characteristics of TIPS may be very poor guides to their future performance. Nevertheless, the best environments for TIPS to provide offsets to equities will likely be in rising inflation environments.
Yet, most modern equity market shocks have reflected confidence shocks and declining inflation. In such environments, TIPS have the same limited benefits to offset equity risk as nominal bonds, but they cost more (in terms of lower income) due to the cost of the inflation protection.
A stock by any other name…
Other possibilities for alternatives to bonds may include “bond-like” equities. Yet as much as high-quality dividend paying stocks, utilities stocks, or REITs may have bond-like characteristics such as higher income or lower beta, at the most critical time of equity drawdowns, they still behave more like stocks than bonds.
That results in equity correlation when you can least tolerate it, undermining the use of bond-like stocks as a fixed income replacement.
“Bond-like” stocks behave like… stocks
Performance metrics of dividend stocks, utilities, and REITs
Correlation with S&P 500+0.87+0.42+0.57Beta to S&P 500+0.81+0.43+0.72Correlation when S&P 500 declines more than 5%+0.70+0.52+0.66
Source: Bloomberg, from 1/1/1990 to 9/30/2020. “Dividend stocks” represented by the S&P 500 Dividend Aristocrats Index. “Utilities” represented by the S&P Utilities Index. “REITs” represented by the S&P US REITs Index.
So… are you just going to jump anyway?
Based on our previous analysis, it appears that none of these three options alone offer a durable alternative to the traditional bond ballast against equity market downturns.
It’s time to build a new parachute
Instead of finding a different asset class to plug in for bonds, we highlight how alternative approaches to both the equity and fixed income allocation may help generate the ballast missing from bonds.
Jeffrey Rosenberg, CFA, Managing Director, leads active and factor investments for mutual funds, institutional portfolios and ETFs within BlackRock's Systematic Fixed ...