The Fixed Income Dilemma

December 6, 2021 | By: David Stonehouse

The Fixed Income Dilemma

Strategies to enhance the “40” side of a 60/40 investment portfolio.

The investment industry has long espoused the virtues of the 60/40 asset allocation model – that is, 60% of a portfolio held in equities and 40% in bonds. For decades, through financial crises and stock bubbles, the model has largely rewarded investors’ faith, consistently delivering a healthy balance of solid returns and decent risk mitigation over time. Yet today, more and more investors are questioning the wisdom of 60/40, and much of the concern centres on the “40” side of the ratio. With yields low and the prospect of rising rates creating price volatility, many are wondering whether bonds can any longer provide either the returns or the downside protection that they once did – and whether it’s time to rethink a simple 40% allocation to fixed income in a balanced portfolio.

We see their point: in the current environment it would be prudent for investors to consider ways to generate yield and mitigate risk that go beyond just allocating 40% of assets into traditional bonds. We also believe, however, that the relevant question is as much (or more) about the assets held in that fixed income allocation as it is about the overall proportion of fixed income in a portfolio. Options beyond traditional bonds do exist, and they may provide investors with strategies for getting more out of fixed income even in these very challenging times – if they are prepared to think a little bit differently.

Before we explore those alternatives, let’s look at what bonds are supposed to do in a portfolio. Historically, they have had two primary purposes: to provide yield and to dampen volatility. One could allocate 100% of a portfolio into stocks, and that would invariably generate higher returns over sufficiently long time periods. Yet very few investors have the stomach for such risky exposures during major bear markets, and bonds have historically provided a cushion to stock-market blows. In the event of an equity downturn, bond yields usually plummet (and bond prices rise) as investors flee to safety, and that mitigates an investor’s losses.

Consider how this works in a 60/40 portfolio. Let’s hypothesize a bear market in which stocks decline by 40%. In our model portfolio, that creates a 24% decline in overall value. However, at the same time, bond yields might decline by 2%, translating into, say, a 10% price appreciation in the fixed income part of the portfolio (depending on the starting yield and duration) and generating a 4% positive effect on portfolio value. So, instead of losing 40% (as they would in a stock-only portfolio), the 60/40 investor will end up down “only” 20%. Of course, during strong stock markets, the fixed income allocation would produce lower returns than equities, but it would be less volatile – and may help investors sleep better at night.

Or at least fixed income should do that. The trouble is that in recent years, the effectiveness of bonds in generating yield has been impaired, and post-pandemic, their near-zero yields have jeopardized their ability to mitigate risk. The yield problem is clear: yields are very low and will likely remain low even after policymakers finish the tightening cycle that many expect in the next few years. That problem leads to an even more troublesome one: because yields are so low, the effectiveness of bonds to protect against portfolio losses is also lower. If a bond’s yield is already at 1.5%, it is more difficult for it to fall by two percentage points in a bear market. If yields have less room to fall, prices have less room to rise, meaning bonds will do less to offset equity losses. It is not that bonds can no longer dampen volatility; it’s just that they may not be able to do it as well as they used to.

It’s important to note here that bonds still have an important function in a portfolio. They have lower volatility than stocks, and in an adverse environment they should still help mitigate the decline of equities. Low yields, however, cap the downside protection they offer. And today, with the prospect of central banks tightening monetary conditions, bond returns have turned modestly negative – making a challenging fixed income landscape even more so.

How can investors respond? One obvious tactic is to shorten duration in bond allocations, mitigating the risk of rising rates. The challenge, however, is timing. For much of the past 40 years – the secular bull market in bonds – investors have generally responded by reducing duration, simply because they did not believe rates could keep going lower. And yet rates have kept going lower. Moreover, there is no guarantee the U.S. Federal Reserve will hike rates as much – or at all – as nearly everyone expects late next year and beyond. A second drawback of this tactic is that short-term bonds usually yield less than longer-term bonds, meaning that investors will be paid even less by focusing on short-duration instruments. In addition, when yields do fall, short-duration bonds don’t rally as much as long-duration bonds.

Another response would be to conclude that the 60/40 model is broken and simply allocate a greater proportion of assets to equities. Indeed, some investors have adopted this approach. The problem is that the starting point of low yields has already generated a rush towards stocks. Valuations have moved much higher, so long-run future-expected returns have become more challenged. A higher equity allocation clearly also increases downside risk. Thus the 60/40 investor’s dilemma exists on both sides of the equation.

Rather than throw out the baby with the bathwater and abandon the 60/40 model, we believe a more prudent response for investors might be to “upgrade” it by resetting their fixed income exposures. One does not have to hold traditional bonds exclusively, and there are solid options that approximate bonds’ benefits while mitigating some of their risks.

  • If you believe inflation is going to cause yields to rise, inflation-linked bonds are an option. Note that ILBs have enjoyed a stellar run in the past 18 months, and future gains may be harder to come by if inflation ends up being just a cyclical phenomenon.

  • High-yield bonds and Emerging Market debt both offer the potential for higher returns through far more attractive yields, although with higher risk. In high-yield, investors assume more credit risk; in EM debt, they take on more political and currency risk. Nevertheless, high-yield bonds in particular have provided attractive absolute and risk-adjusted returns historically, even after adjusting for defaults (which can be partially offset by recovering some residual value in the company’s assets).

  • To mitigate rate sensitivity, investors can consider exposures to floating rate (or senior) loans, which also can offer higher yields and diversification benefits, although these instruments too involve credit risk.

  • Convertible bonds, which are corporate debt instruments that can be exchanged for common shares, offer the potential for lower rate sensitivity and better returns than traditional bonds might. They also typically offer much better downside protection than stocks. It is important to be aware that they tend to be more volatile than regular bonds, since convertibles’ value is somewhat exposed to the issuing company’s share price.

  • Real assets like infrastructure, while not a fixed income solution per se, can offer inflation protection and the potential for steady long-term returns. Resources can also be a good source of inflation protection, although they tend to be more volatile.

  • Derivative strategies can hedge against rising interest rates or capitalize on foreign exchange currency opportunities, which have the potential to mitigate risk and boost returns without leverage.

  • Private credit – corporate debt not issued or traded on public markets – can generate higher yields and enhanced risk-adjusted total returns in a fixed income portfolio, while also providing more diversification and lower volatility, albeit with lower liquidity.

Adding Private Credit to a Hypothetical 60/40 Portfolio

Risk/Reward graph
Source: Morningstar Direct and Preqin. For Illustration purposes only. The hypothetical performance presented is based on a combination of index returns. One cannot invest in an index. Hypothetical performance is not necessarily indicative of future results. Based on quarterly performance data as of March 31, 2021. Equities represented by the MSCI All-Country World Index Total Return Index. Bonds represented by the Bloomberg Global Aggregate Bond Total Return Index. Private Debt represented by Preqin’s Private Debt Quarterly Index.

Finally, a prudent approach to the challenges of 60/40 might go beyond resetting exposures. It might also involve resetting expectations – on both sides of the equation. Even if the Fed raises rates, fixed income yields will likely remain low by historical standards, and that obviously will be a headwind to income generation, although it will also mitigate capital loss potential from rising yields. On the equity side, returns might also be challenged because valuations are high relative to historical norms. After such a stellar post-Global Financial Crisis run for U.S. stocks in particular, it makes sense to be wary of any assumptions of double-digit annual equity returns over the long term.

That makes thinking differently about fixed-income allocations even more important. None of the options to traditional bonds outlined above is a silver bullet, and all involve both advantages and risks. Yet, when put together in a “group effort,” they demonstrate that there is plenty of room for innovation and manoeuvrability – and the potential for enhancing outcomes even within a 60/40 portfolio model.


David Stonehouse
David Stonehouse, MBA, CFA®
Senior Vice-President and Head of North American and Specialty Investments
AGF Investments Inc.
Senior Vice-President and Head of North American and Specialty Investments

David Stonehouse oversees AGF’s North American and Specialty Investments teams while maintaining direct portfolio management responsibilities for his current mandates.

With more than two decades of experience managing both fixed income and balanced mandates, David employs a rigorous and disciplined investment process combining a top-down approach to duration and asset allocation with a bottom-up approach to security selection. David is a member of The Office of the CIO – a new structure within AGF’s Investment Management team. This leadership structure encourages and further embeds collaboration and active accountability across the Investment Management team and the broader organization.

David received a B.Sc. in Applied Science from Queen’s University, an MBA in Finance and Accounting from McMaster University and is a CFA® charterholder.

Registered as a Portfolio Manager under AGF Investments Inc. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

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