By Sam Liddle, Director at Church House Investment Management
A long time ago, in the halcyon days before the Great Financial Crisis and the flood of cheap money from central banks that followed in its wake, prudent investors were advised to use a 60/40 portfolio model as an ideal balance for generating decent total returns with reduced volatility.
The 60% of their assets invested in stock markets provided potential for strong performance, while the balance in fixed interest holdings would step in to bolster returns when equity markets were falling. If equities outperformed and the 60% started to creep up, the portfolio was rebalanced to maintain that ‘optimal’ ratio.
And for many years it worked well. But quantitative easing and the rock-bottom interest rates that accompanied it put a massive spanner in the works, triggering a prolonged bull market for equities and at the same time suppressing bond yields to a fraction of their historic levels.
Investors with 60/40 portfolio models saw diminishing attraction in buying expensive bonds with minimal yields, especially when to do so meant selling high-performing equities. It’s unsurprising, then, that many have turned away from bonds as the bedrock of a balanced portfolio in recent years.
But 2022’s complex inflationary pressures – rooted in the fallout from the Covid pandemic and exacerbated by war in Ukraine – have caused turbulence across the board.
Equity investors have seen markets plunge in the face of souring sentiment, fears of slowing economic growth and multiple interest rate rises, as central banks attempt to contain rising prices.
That toxic combination of inflation and rising rates has also been deeply painful for bond investors. The Bloomberg Global Aggregate index of government and investment-grade corporate bonds had fallen into bear territory for the first time ever by early September 2022, losing 20% from its peak of January 2021.
In the UK, a series of chaotic political events kicked off by former chancellor Kwasi Kwarteng’s disastrous mini-Budget have been compounding the market mayhem. The UK’s ‘risk-free’ 10-year gilt yields peaked at around 4.5% in response, up from 1% at the start of the year, before retreating a little to just under 4% (as at 20th October 2022).
But while carnage in both equity and bond markets may feel as though it has left 60/40 investors with nowhere to hide, short-duration issuance has been relatively resilient.
Moreover, there is a strong argument fixed interest now offers investors opportunities not seen for many years, provided they focus on bonds that will mature within, say, five years.
The fact is that there is little now to be gained by investing in long-duration holdings: the yield curve is pretty flat between 10-year to 30-year gilts, at just under 4%. Yet that’s only marginally ahead of the 3.6% yields available on a two-year holding with a great deal less risk and uncertainty attached.
As far as corporate bonds are concerned, credit spreads have widened dramatically this year, pushing yields up by about 2% to around 5.5% on two-year investment grade credit.
Indeed, as we have taken advantage of falling bond prices, the annualised yield to redemption for our own Investment Grade Fixed Interest fund now stands at 5.6% (that reflects the capital uplift from the average price paid for the bonds if they are held to maturity, plus the income stream over that time).
In comparison to the uncertain outlook for equity markets, we consider that relatively secure return to be a very attractive proposition.
Of course, there is a risk that the issuers could go bust, and the risk of default is likely to increase in coming months as the UK battles probable recession. But that is why a focus on high-quality, highly rated bonds is preferable to high-yield alternatives. Not only are companies issuing high-yield debt inherently more vulnerable in a downturn, but they typically have to borrow to repay their debt, which becomes more of a challenge for them in the face of rising rates.
So, have 60/40 portfolios had their day?
We would argue absolutely not. Certainly, the role of high-quality short-duration credit was harder to justify in the days of free money and roaring equities markets; but this year’s seismic shifts have re-established its position as a core asset class providing reliable returns and effectively reducing portfolio volatility.