Investors with a moderate tolerance for risk have traditionally held portfolios with a 60%/40% balance between stocks and bonds. But in today’s markets, a portfolio with this equity / fixed income allocation may not deliver the results these investors have come to expect. Historically, investors in core bond funds could reasonably expect to receive about 5% a year in total return from their investment. Bond prices rise as interest rates fall, and rates declined steadily over the 40-year period from 1/1/1980 to 12/31/2020 (Figure 1).

Figure 1 – Declining interest rates supported Core Fixed Income returns (1/1/1980–12/31/2020)
Figure 1 – Declining interest rates supported Core Fixed Income returns (1/1/1980–12/31/2020)
Source: Morningstar

But today, in an environment where rates are rising instead of falling, traditional fixed income with interest rate sensitivity may underperform its historical average. One solution has been to replace a portion of this fixed income allocation with stock exposure, as much as 20% in some cases. But this creates another problem. Strategically overweighting stocks relative to bonds ignores the utility of fixed income as a risk reducer and significantly increases portfolio risk. During the short but sharp Covid-19 selloff in 2020, a portfolio overweight equity significantly underperformed a traditional 60/40 mix (Figure 2).

Figure 2 – Portfolios with greater stock exposure lost more during the Covid selloff

Portfolio Stock/Bond Mix Covid Selloff (2/16/20–3/21/20)
60% S&P 500 / 40% Morningstar US Fund Intermediate Core Bond
-20.5%
60% S&P 500 / 40% Morningstar US Fund Intermediate Core Plus Bond
-21.6%
80% S&P 500 / 20% Morningstar US Fund Intermediate Core Bond
-26.1%
80% S&P 500 / 20% Morningstar US Fund Intermediate Core Plus Bond
-26.6%
Source: Morningstar

Adjusting the sources of risk
This increased downside potential matters because investors tend to be risk averse and reactionary. When a portfolio exhibits downside risk beyond their tolerance level, investors may choose to abandon their holdings and move to cash. This is generally the worst course of action, as it undermines long-term performance and reduces the probability of reaching future goals.

But instead of reducing the allocation to bonds, it may make sense to change the sources of bond risk. Rather than buying a handful of core bond or core plus bond managers, investors may have to get more tactical and specific with their fixed income positions. One choice is to allocate to specific fixed income sectors, as opposed to a broad mandate manager. This can help to control duration (the sensitivity of a bond’s price to changes in interest rates) or the type of credit exposure. Another choice is to use non-traditional strategies like option-writing or market neutral funds as fixed income alternatives that have low correlations to interest rates and/or credit.

The most important thing to consider when choosing how to allocate positions within a portfolio’s fixed income sleeve is the overall risk of the sleeve, and to make sure it still behaves like traditional fixed income risk once allocations have been decided. If investors start using equities or equity alternatives in place of fixed income, they will introduce equity risk, which has the potential to increase the overall risk of the portfolio to something beyond their risk tolerance.
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