Brave New Bond World

October 30, 2020

[This article appears in our November 2020 issue of ETF Report.]

 

For a very long time, a 60/40 stock-to-bond portfolio split was the typical advice for the average investor, with the expectation of increasing bond exposure as they neared and then entered retirement.

Then the Great Financial Crisis tossed everything on its head, including the world of bonds, which then faced unbeknownst years of a concerted global effort to lower rates.

But this is really the first year where I have seen such widespread complaints about fixed income “not doing its job.” Toss on the coronavirus pandemic and the market crash to a near-negative-rate environment, and the need for safety, diversification and portfolio ballast comes into sharp relief.

Maybe it’s time to rethink the perhaps-outdated use of bonds as a one-stop shop when looking for something to balance out stocks.

There are many ways to dampen the volatility of stocks to give your portfolio some ballast and diversification. If you look at charts of multiple asset classes in the last market crash, a broad bond allocation actually seemed to do what it was supposed to, as did physical gold.

Bonds Still A Balancing Force
The broad investment-grade market exhibited steady performance with a mild decline and quick recovery, while stocks crashed dramatically, and gold has soared since the market blowup. And if you really want diversification—or at least a strong hedge—an allocation to a volatility-linked ETF could be very rewarding.

For example, the SPDR S&P 500 ETF Trust (SPY) bottomed out on March 23, falling more than 30% year to date. At the same time, the iShares Core U.S. Aggregate Bond ETF (AGG) was up 0.66%, and the SPDR Gold Trust (GLD) was up more than 2%.

During that same time period, the iPath Series B S&P 500 VIX Short Term Futures ETN (VXX), which covers short-term VIX futures, was up more than 350%. Clearly, a counterweight to stocks is not exactly hard to find.

But income … well, that’s another story. MLP ETFs seem to offer  the most income, but since they’re mostly dependent on the energy space, their performance has been as abysmal as the energy sector itself.

The Global X MLP ETF (MLPA) has a distribution yield well over 16%, but on March 23, it was down nearly 63% year to date. Indeed, when it comes to equities that provide dividends—as with bonds—the more yield you get, the worse the price performance.

Fixed income offers some yield, with the FlexShares High Yield Value-Scored Bond Index Fund (HYGV) at the top of the yield-to-maturity rankings, offering more than 7%. But that’s a high yield fund. AGG offers a yield to maturity of a little more than 1%. You’ve got to take on quite a bit more risk to get that extra yield.

Another Path?
So maybe the goal should be to find ways to remove risk from other parts of your portfolio. The newest ETF risk management tool—defined outcome ETFs—could be a reasonable alternative, though they don’t pay any dividends, and come with derivatives risk. But with a risk-managed approach to equities, perhaps an investor could offset that by taking a little more risk in bonds to gain more income.

The bond market has evolved from the version that was the basis for the traditional 60/40 portfolio, but many have been slow to shift their attention to the new tools available to help achieve their goals. That may involve expanding the number of asset classes they invest in and toggling their risk exposures accordingly.

But all that really means is, more than ever, investors need to understand how financial markets work, as well as risk trade-offs and possible pitfalls. Bonds are still an important part of a portfolio, but the growing complexity of financial markets means they shouldn’t be the only tool an investor reaches for.

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