Banking

Why the 60/40 model is here to stay

Although bond yields remain close to historic lows, they have trended higher since August 2020 as prices have fallen.

At the time of writing, the 10-year US Treasury yield is up more than 40 basis points (bps) in 2021, with the 10-year gilt yielding around 39bps more than at the start of the year.

The downward pressure on bond prices stems from recent economic data.

Headline inflation figures rose across key markets in the first half of 2021, prompting markets to price in sooner-than-expected interest rate hikes from central banks as a means to prevent higher inflation taking hold.

Our economists do not expect rises in inflation in Europe to persist and think the pace of interest-rate rises will be gradual, but concerns remain about having a fixed allocation to government debt since a bond’s price will fall as yields rise.

It is important to remember that while rising interest rates can mute the performance of bonds over short time horizons, the impact of rising rates over the longer term can be different.

Ultimately, the primary reason for holding bonds in a long-term multi-asset portfolio is to diversify the investor’s exposure to stock-market shocks. Government bonds are not there to drive returns.

Shock absorbers

Our analysis of markets over the past 20 years not only confirms that there is an inverse correlation between global equities and global bonds but also shows that the longer equity markets decline, the more likely bonds will play a stabilising role in a portfolio. This remains the case independently of the level of bond yields.

There are some instances when bonds fall in concert with equities. The most recent occurrence was the ‘Covid sell-off’ in March 2020, which saw bonds and equities fall, briefly, in tandem.

Our research found that bonds and equities fell simultaneously roughly 30% of the time, but this was generally as a result of transient rather than systematic factors.

Once markets were given enough time to factor in the monetary policy responses, we saw the usual inverse relationship between bonds and shares re-established.

Furthermore, we did not find a better alternative to government bonds within the fixed income universe for protecting portfolios from equity downside risk.

Will rising rates drag returns down?

For clients worried about the declining value of their bond holdings, looking at total return rather than price return is more appropriate for long-term investors.

In an environment where rates are expected to rise, the higher yields of longer-term bonds reflect the trade-offs of short-term capital loss versus higher income.

In other words, investors suffer a short term pain for a long term gain.

That is because as interest rates rise, the income return and price return tend to move in opposite directions, with the income return offsetting the declining price return over time.

The recent increase in market interest rates has led us to raise our 10-year annualised return forecasts by half to a full percentage point for a number of markets, including UK aggregate bonds and global aggregate bonds ex. UK (hedged) – although long-term returns are still expected to be muted.

Investors concerned about the inflation environment could also consider holding a fraction of their portfolios in index-linked bonds to manage any inflation risk.

There is no silver bullet

The outlook for different asset classes will change in response to evolving assessments of economic and market conditions, which is why we encourage advisers to ensure client portfolios are well diversified across asset classes, regions and sectors, in-line with their risk tolerances.

Investors who want to take more risk in pursuit of higher returns can adjust the ratio of equities to bonds in their portfolio accordingly.

In a low-return environment, the solution is not about beating the 60/40 model, but about finding the right asset allocation that can give investors fair odds of achieving their goals in the most efficient way.

The last thing investors should do is abandon the principles of good asset allocation. There is not a silver bullet alternative.

Giulio Renzi-Ricci is senior investment strategist at Vanguard Europe

Most Related Links :
todayuknews Governmental News Finance News

Source link

Back to top button