The case for a 60 per cent equity, 40 per cent bond allocation is weaker than ever, according to Bank of America Merrill Lynch, which does not expect the traditional asset allocation model to survive into the next decade.
The 60/40 equity-bond split has stood as a traditional model of asset allocation for cautious investors for many decades.
However, the low growth, low inflation and low-rate environment of the post-global financial crisis era has made the model look increasingly outdated.
The model could even slip into irrelevance in the next decade, according to the Bank of America Merrill Lynch’s research investment committee.
“The relationship between asset classes has changed so much that many investors now buy equities not for future growth but for current income, and buy bonds to participate in price rallies,” the bank noted.
A number of factors have been behind the shift: high debt burdens restricting demand and animal spirits; deleveraging restricting supply of credit; technology disrupting established industries; and ageing demographics depressing growth.
“60/40 may have thrived in the 2000s and 2010s, but it will not survive the 2020s,” the committee noted.
“Either global growth and inflation will accelerate, handing huge losses to bondholders, or monetary policy will prove increasingly impotent to confront secular stagnation, resulting in more frequent recession and bear markets.”
There are three threats to bonds: diversification, volatility and positioning.
The first threat – diversification – underlines the fact that one of the fundamental premises of the 60/40 portfolio is that bonds can hedge against risks to growth, while equities hedge against inflation: “Their returns are negatively correlated”.
“Typically, when stocks decline, we see investors rushing to buy US Treasury bonds and other safe assets,” the bank noted.
Source: Bank of America Merrill Lynch
“This tendency of bonds to rally when stocks drop - the negative correlation between bonds and equities – is the basis for a conventional allocation of 60 per cent to stocks and 40 per cent to bonds.
“But this assumption was only true over the past two decades and was mostly false over the prior 65 years.”
It added: “The big risk is that the correlation could flip and now the longest period of negative correlation in history is coming to an end as policymakers jolt markets with attempts to boost growth.”
The second issue facing the traditional 60/40 model is volatility, something that was not traditionally associated with bonds until recent years.
“In the past three years the risk-adjusted returns in treasuries were worse than in every other asset class except commodities,” the research investment committee said.
“The future may look very much like the recent past, as duration risk is at record highs, forward-looking implied volatility is at four-year highs, and the yield per unit of risk is worse than in every other part of fixed income.”
Finally, positioning in the asset class has become very crowded as investors have had to take on increasingly more risk to achieve the same levels of yield they had become accustomed in the past.
In recent years, international investors have piled into US dollar denominated bonds with more money continuing to flow into fixed income strategies.
“Crowded positioning means that natural swings in bond prices may be exacerbated as active investors rebalance their holdings or the macro outlook changes,” said the bank.
Nevertheless, there are ways that investors can mitigate the threats to bonds in their own portfolios, allowing them to ‘build a better bond shelter’.
One, higher risk way that investors can buy higher-yielding stocks in “bombed-out” cyclical sectors.
Bank of America Merrill Lynch chief investment strategist Michael Hartnett said such stocks will likely outperform in a sell-off as “people are forced to sell what they own – defensives and technology – not what they don’t – financials, industrials and materials”.
“We may be closer to late- than mid-cycle but equity risk is still worth taking, especially in companies with attractive yields at fair multiples,” the bank noted.
Another way that investors can try to mitigate threats to their fixed income allocation is by holding more short-duration high yield corporate bonds and bank floating rate note exposure.
“US corporate leverage has actually declined ex-growth sectors [technology, healthcare and consumer discretionary] and in high yield material utilities have improved leverage ratios in recent years,” the committee reported.
“Bank loans are reviled and are a contrarian buy on plunging supply, our desire to fade recession fears and the under-priced risk of a 2020 spike in yields.”
Regardless, the bank said, investors may need to start thinking now about life after 60/40.
“The future of asset allocation may look radically different from the recent past and it is time to start planning for what comes after the end of 60/40,” it concluded.