Understanding 60/40 portfolio's reaction to this year's market turmoil

A trifecta of truly unprecedented market shocks — rampant inflation, historically volatile interest rates and slowing growth — have led to an uncomfortable (but necessary) simultaneous repricing in fixed-income and equity markets. After the dramatic sell-offs that came with that repricing, many investors are wondering if high stock/bond correlations mean the traditional 60/40 portfolio has lost its allure — i.e., if the "40," or bond portion, of the 60/40 has lost its diversification potential.

We would argue that this year's parallel decline in both equity and fixed income, due to the aforementioned market shocks, should be viewed as a correction, not a crisis.

That distinction — correction vs. crisis — is important to bear in mind. While painful, corrections are a critical function of a healthy market. Crises, on the other hand, are existential in nature and imply that something is actually broken in the markets and/or economy. Investors are well-served to remember that bonds are not always "correction" protection. More importantly, past market sell-offs demonstrate that the bond market has consistently been able to provide a ballast during times of actual "crisis."Over the past 20 years, Treasuries have delivered the diversification investors seek in those times. Notably, this diversification potential comes regardless of where interest rates stand.

Going into the COVID-19 crisis, the U.S. 10-year Treasury yield was 1.6% — less than half of where it stands today — and fell to 0.8% Despite those (at the time) historically low rates, bonds still rallied, returning 5.3% over the course of the COVID equity sell-off. This demonstrates that, regardless of how low rates are, investors still turn to sovereign bonds for crisis protection.

As another historical example, rates at the start of the 2011 downturn were similar to today's levels. At that time, the U.S.'s credit rating was downgraded. Despite that downgrade being a root cause of the crisis, the reputation of U.S. Treasuries as the largest and most liquid safe-haven asset class held strong, and the market reacted to the downturn by — believe it or not — buying U.S. Treasuries. In other words, the U.S. government's ability to repay its debt was downgraded and its borrowing costs got cheaper as a result.

Even with this historical precedent in favor of bonds as strategic crisis protection, this year has still been a particularly disorienting experience for investors because it wasn't just an equity bear market; bonds suffered historical losses this year at the same time. That combination led to historic losses for the 60/40 portfolio that so many investors have relied upon to provide the diversification that is supposed to help them weather downturns.

When, in turn, the headlines proclaimed the supposed death of the 60/40 portfolio, they were generally questioning whether the 40% bond allocation can continue to diversify the 60% equities portion of the portfolio, given the recent high correlations. Instead of worrying about correlation noise, we think investors should instead focus on the signal of core bonds as a strategic risk manager.

Recession or not, we believe it's more important to recognize that we are indeed entering a slower growth environment. With the 10-year Treasury now near 4%, the yield cushion on core fixed income is relatively high and its role as risk manager is as important as ever.

The historic volatility and losses that impacted virtually all major fixed-income asset classes throughout the first half of 2022 has delivered an obvious silver lining: Rates are higher, valuations are cheaper and fixed-income investors now have a large opportunity set they can draw on to reallocate and rebalance their asset allocations. In the current environment, we are primarily focused on two specific types of fixed-income solutions: defensive and dynamic.

Defensive: The year-to-date sell-off across all fixed income provides many opportunities for investors to increase their exposure to historically defensive, high-quality investment grade sectors carrying yields that have been more recently reserved for higher-risk areas of the market. Among these defensive sectors, we see opportunities to add to several areas of the securitized markets — particularly agency mortgage-backed securities, where yields are materially higher than in many other defensive sectors. In addition to relatively high yields, we are mindful that these defensive sectors also offer greater return potential if growth meaningfully slows, we enter a recessionary environment and rates go down from this point forward.

Elsewhere in the defensive universe, the yield-curve inversion is a boon to conservative core fixed-income investors: the inversion means short-term bonds now potentially generate higher yield than intermediate term, while at the same time carrying less duration risk.

Dynamic: Whereas purely "defensive" fixed income consists of only high-quality investment grade sectors, investors willing to take on additional risk within the "40" of their 60/40 portfolio may consider complementing with a solution that dynamically combines some elements of equity diversification with higher income potential. The current environment presents attractive discounts (and even dislocations) in many high-risk and high-yield asset classes. However, investors would be wise to remain cautious and expect further volatility and losses to accompany the current high-return potential of these asset classes. Against this backdrop, dynamic strategies can help "rerisk" core fixed-income overweights and/or "derisk" overly aggressive fixed-income allocations. These types of solutions actively allocate to areas of the market that appear attractive while remaining flexible to increase or decrease the portfolio's risk budget in response to changing market conditions.

In conclusion, we do not believe the 60/40 portfolio is dead, but we do think it is experiencing something of a midlife crisis in the sense that it's experiencing rapid change after what was a roughly 40-year bull market in core fixed income. In our view, we have now reached the point where investors should attempt to put recent volatility behind them, view the current landscape as a blank slate and seek to take advantage of new opportunities in a higher-yield environment. The question shouldn't be if they should take advantage, but how — and the solutions we have outlined can play a critical role.

This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.