Investing Without a Parachute

by Jeffrey Rosenberg of BlackRock, 11/3/20

The outlook for protracted zero interest rate policy with historically low long-term interest rates means fixed income markets offer both lower returns and less equity diversification potential. Together, these pose unique challenges to the traditional 60/40 portfolio. The loss of bond ballast, or the ability for bonds to offset equities in downturns, is an important, but often overlooked, consequence of the Fed’s promise to hold rates at zero for the foreseeable future.

Easy answers entail tough tradeoffs. Increasing exposure to credit may help solve for low levels of yield but comes at the cost of exacerbating the equity diversification problem. Doing nothing at all still results in a riskier overall portfolio of debt and equity, as the sensitivity of rates to falling stocks stands at about half its historical norm.

For investors unwilling or unable to handle the rise in overall portfolio risk, we investigate several potential solutions for solving the fixed income diversification problem. Without action, we may be at risk of investing without a parachute.

What happened to the parachute?

In Part I of Investing Without a Parachute we argued that because both long-term and short-term interest rates were close to their effective lower bounds, or the level where rates are so low that they cannot drop that much further, bonds have lost a significant portion of their potential to diversify equities. This lower bound limits the magnitude that bond prices can appreciate when equity prices drop. This change in prospective fixed income return behavior requires a rethinking of the role of bonds in a traditional 60/40 portfolio.

September 2020: A hard landing

The September 2020 sell-off in equity markets provides the first case study on the potential future of fixed income returns. The month illustrates how different the bond market behaves today relative to how we might have expected based on history—even as recent as the start of the year.

Treasury bond returns over the month were about half of what a similar magnitude equity sell-off would have implied based on the longer run history of rate/equity return relationships. Even though bond yields still fell (the correlation of stock and bond returns is still negative) the strength of that relationship is lower (the beta is lower).

A simple proposition for why the degree of responsiveness is lower is the proximity to the zero-lower bound. Though policy rates in other countries have gone negative, policy makers at the Federal Reserve have repeatedly highlighted their belief that for the US, the effective lower bound of interest rates is zero. So, with less room to fall, interest rates likely respond less to equity market declines going forward.

By our estimates, the beta of 10-year and 30-year US Treasury yields stand at about half of their long-term averages. In the shorter end of the yield curve (less than 5-year maturities), the beta is effectively zero, as these rates already reflect the expectations that the Fed will maintain an extended period of zero interest rates until at least 2023.