The failure of bonds to diversify stocks in 2022 sparked a debate about what to do with the traditional 60/40 portfolio. In this piece, we demonstrate for clients hesitant to move beyond fixed income, that there are attractive investment solutions within the asset class.
Why Bonds Failed in 2022
As the Fed aggressively hiked rates to combat inflation, both stocks and bonds declined simultaneously, leading to significant losses in 60/40 portfolios. There are two reasons why this classic model failed:
- Stocks, as long-duration assets, were repriced in response to the new interest rate environment. Meanwhile, bond prices fell as yields rose, reflecting their inherent inverse relationship.
- Stock market downturns are typically driven by panic, which was notably absent in 2022. Without meaningful spikes in the VIX, there was no 'flight to safety' to support bond prices.
Fixed Income Investments That Outperformed Bonds in 2022
Despite the weakness in aggregate bonds, not all fixed income investments were hammered by the Fed's high rates in 2022; some were actually lifted. Bank loans, for example, lost only a modest 3.2%, while private credit GAINED 6.5% during the calendar year.
This performance dispersion was attributable to differences in credit quality, duration, and structure. Bank loans and private credit are floating-rate instruments, with their principal largely unaffected by rising rates, while their income benefits from the increases.
Diving Deeper Into Fixed Income
Fixed-income securities are debt instruments that pay interest. For simplicity, here we divide the asset class into Treasury bonds, investment-grade corporate bonds, high-yield corporate bonds, bank loans, and private credit.
Looking beneath the surface of aggregate bonds over the past 20 years, several patterns emerge:
- During a stock crisis, Treasury bonds are the best 'flight to safety' asset. IEF gained a remarkable 16.9% in the 2008 financial crisis, significantly outpacing AGG's 6.5%.
- Non-government credits are more correlated with stocks than government bonds, offering less diversification during stock downturns.
- Over the entire 20-year period, public credit significantly underperformed private credit, with a standard deviation three times higher.
A Combination of Treasuries and Private Debt Outperformed Aggregate Bonds
Outside of 2022, bonds remained resilient and helped alleviate the pain of every market downturn over the past 20 years. However, they have also been a performance drag: the 60/40 portfolio trailed stocks by 2.8% annually.
What if we avoid fixed income segments that are highly correlated with stocks - such as corporate bonds - and instead adopt a barbell approach that amplifies the safeguard component (Treasury bonds) and the yield component (private credit)? The result is a noticeable improvement in both performance and the Sharpe Ratio.
Replacing AGG with Treasury bonds (IEF) modestly improves the risk-return profile and enhances crisis alpha during market corrections and downturns, suggesting that the 60/40 can be made 'safer' without sacrificing returns. Conversely, replacing AGG with private direct lending (CCLFX) yields a more substantial performance boost without increasing risk. A 'middle of the road' approach that splits the 40% between IEF and CCLFX increases the return by 1% annually while maintaining comparable crisis performance.
Additional Fixed Income Management Tools
This example highlights the potential to optimize fixed-income strategies for enhanced performance and diversification, representing just one of many approaches to consider. These strategies should be tailored to align with client objectives and take into account other factors, such as:
- Drawdown management. Different types of credit show varying magnitudes and timings of drawdowns.
- Duration Management. For example, even within Treasuries, short-, medium-, and long-duration bonds delivered drastically different returns in 2022..
- Investment selection. For example, there's a broad array of strategies in the realm of private credit, including direct lending, asset-based lending, CLOs, senior/junior debts, and special situations, each with distinct exposures.
- Evolving environment. Increasing national debt, the rise of gold and Bitcoin, and a more sophisticated Federal Reserve all contribute to a changing backdrop for fixed income.
Reach out to a BAS representative to discuss customized solutions that will enhance asset allocation efficiency for your clients.
Footnotes:
1. Data source: Yahoo Finance. Tables: compiled by the author. All returns are net-of-fees.
2. HYG inception: 5/2007. From 10/2004 - 4/2007: VWEHX-Vanguard High-Yield Corporate Fund Investor Shares.
3. CCLFX inception: 6/2019. From 10/2004 - 5/2019: CDLI-S Cliffwater Direct Lending Senior Loan Index.