In the midst of a global pandemic, many traditional fixed income portfolios did not provide the expected diversification benefit. In March of 2020, bonds with government backing, like U.S. Treasuries, were some of the few sources of positive return in fixed income. High yield indices dropped by approximately 20% during the worst of the COVID-19 driven market rout. In late March, the Federal Reserve provided unprecedented liquidity into the fixed income markets. Between March and April, the Fed injected more than $3 trillion into the market, averting a painful experience for most fixed income investors. Investors that held longer duration fixed income strategies throughout 2020 enjoyed returns reaching north of 10%. Looking forward, we question the sustainability of these fixed income returns.
Barron’s, The Financial Times, Kiplinger and others, have all written articles discussing the challenges surrounding the traditional 60/40 portfolio. The crux of most of these articles is that the “40” in 60/40 will no longer provide a sustainable, consistent yield, nor the steady values desired to offset volatility in equities. According to a research piece released by JPMorgan strategists in October, today’s environment is “forcing adherents of the classic investing strategy of 60% stocks and 40% bonds to look further afield.” They go on to state that U.S. fixed income investors are unlikely to earn much more than 3% per year over the next decade, appropriately phrasing it as a new “return crisis.”
Why are so many pundits discussing the challenges around a traditional 60/40 portfolio? Essentially they are saying that fixed income’s risk/return profile has changed, and it will no longer provide the traditional benefits to a balanced portfolio. Fixed income serves four key roles in a portfolio:
- Capital preservation
- Protection from deflation
Looking back over the last few decades, traditional fixed income has exceeded its goals. Inflation has trended lower since 1982 and as yields declined with it, investors have seen strong gains in long dated fixed income by following that trend. Additionally, with the exception of the 2008-2009 financial crisis, default rates have been directionally low, maintaining capital preservation as a key attribute. Finally, Treasuries in particular have provided fantastic diversification benefits in periods of chaos as yields had room to fall during “risk-off” periods.
Looking forward, we question the sustainability of these benefits.
We believe there are four key reasons that interest rates are set to rise, challenging the outlook for traditional fixed income in 2021.
- Yields are near historic lows providing inadequate income and the inability to provide enough cash flow to offset almost any potential decline in price
- U.S. Treasury yields are significantly below inflation
- The Federal Reserve’s balance sheet has ballooned to unprecedented levels and any unwind of the balance sheet will challenge the market’s ability to absorb the supply
- As the U.S. readies for a regime change, one must assume that fiscal policy will be more liberal
First, with interest rates near historic lows, yields in traditional fixed income sectors no longer provide investors with adequate levels of income. As we demonstrate later, this lack of income increases interest rate risk in 2021 as there will be little cushion to offset potential bond price declines.