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Death of the 40/60 portfolio

Updated: Dec 31, 2020

The following is a brief summary of a number of Financial Times articles (see sources 1,2) from over the summer, that we think is good material for our readers. The reason for picking up on this subject now, is that as markets have recently experienced volatility, the content of this article becomes more pertinent. Please see the bottom of the article for the links.


Fundamentally, they revolved around the possible death of the 40/60 portfolio.





The first article, “Collapsing rates leave investors dangerously exposed to equity risk” was written by the founder and chief executive officer of Capstone Investment Advisors in New York. He begins by stating that since the Fed has cut rates to the 0% to 0.25% range, the traditional 40/60 portfolio “has finally run its course”.


He explains that 40/60 portfolio is one that is composed of 40% bonds and 60% equity. The idea behind this is that whilst you have the equity-based upside, you also have the added benefit of fixed returns in the form of the coupons from the bonds you own. There is also a hedging benefit of owning bonds – as other forms of return begin to look more dubious; investors may be willing to pay a higher price for the coupon the bond offers. Also, when stocks take a dive often this often results in (or perhaps is accompanied by) a flight to quality and safe havens. Hence, as stocks fall, government bond prices tend to rise, meaning if an investor owns both then he would be “keeping the overall portfolio on an even keel”.


It does not stop there. Besides this hedging benefit, the writer states that since the bond pays a coupon, that “this was an insurance policy the government paid you to own”. So far, so good.


The issue comes, as stated above, when you do not receive a significant coupon return from the bond – which in a near-zero bank rate world, is not unthinkable. For reference, the yield on US Government debt stands at 0.15% and 0.86% for 2 year and 10 year respectively at the time of writing (see source 3). The writer states that the above scenario means the “double benefit has turned into double jeopardy”.


Part one of the issue is that you can no longer get a decent coupon from holding government debt. To contextualise this reduction, where the 10-year Treasury rate now stands at 0.86%, it was 1.92% in only April of this year3.


The second part is that there is a smaller chance of capital appreciation of the government debt in this environment. The writer explains that since the Fed has already stated they are reluctant to move rates into negative territory, there is little room for the yield to fall further (and hence for the price to move upwards). Hence, this “double benefit’ insurance policy has now lost both of its bonuses – a steady and good return from the coupon, and then the capital appreciation side should stocks fall.


The writer goes onto explain that this could mean investors choose to go all in on the equity side in order to make up for the now lessened return from bonds, but this of course means you are left more exposed to downturns.


At the end of this article, the writer briefly highlights some other possible “sources of ballast” – cash, gold and crypto among others. Our aim is to look at some of these other asset classes in future posts.


This is certainly one of the most prevalent issues facing investors today – and the question of where yields on debt go from here is possibly one of the defining issues for asset managers and economists alike going forward.



Links:


1 “Analysts point finger at ‘risk parity’ strategy in market rout”

https://www.ft.com/content/4d5cac08-69f1-11ea-800d-da70cff6e4d3


2 “Collapsing rates leave investors dangerously exposed to equity risk”

https://www.ft.com/content/8a9efc6c-ca71-41e8-bec9-3702f5d67f7e


3 https://markets.ft.com/data – accessed 30/10/2020



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