With some investors declaring that the 60/40 portfolio is dead, Hal Cook, senior investment analyst at Hargreaves Lansdown explores whether bonds can still offer diversification.
Since Covid, correlation of returns between shares and bonds has increased, igniting a fiery debate over whether bonds still diversify portfolios. This has been particularly noticeable recently. During March, when the stock market was up, bond yields were down, so prices were up, and vice versa. This has caused some market commentators to declare that the 60/40 portfolio is dead.
With prices moving in the same direction, where in the past they have moved in opposite directions, it’s true that the diversification provided by bonds within a portfolio focused on shares hasn’t been as strong recently as it has been in the past.
But there are still differences in performance, the biggest one being the size of the price changes. Share price changes tend to be bigger than those for bonds. This matters when stock markets sell off because, while bonds also lose value, they don’t tend to lose anywhere near as much.
An investment portfolio that has both shares and some bonds is therefore likely to lose less during a market shock. For many investors, this is the type of comfort they are looking for from bonds.
There’s also been a consistent theme driving markets in recent years: inflation. Inflation is bad for bonds as it reduces the future value of the fixed payments in real terms. And inflation tends to lead to interest rate increases, which are also bad for bonds. This has caused bonds to lose value at the same time as shares, because the concern is linked to higher inflation.
If inflation falls back into line with target – 2% here in the UK – and is consistent, and/or future stock market shocks are not deemed to be inflationary, shares and bonds could perform more differently again.
And following the bond market reset of 2022, higher bond yields and therefore lower prices offer greater potential for prices to go up again too.
Investors looking beyond bonds have alternatives, but each comes with trade-offs. Gold, private assets, hedge funds, derivative based ‘black box’ protection strategies, property and cash are all potential options. There are pros and cons to all of these around liquidity, complexity and potential returns.
We continue to think bonds are a great way to diversify portfolios. And we think, in future, the correlation of returns between shares and bonds will reduce again.
Main image: hector-j-rivas-V0OsHPIh4To-unsplash
