With bonds regaining their shock-absorption properties, advisors urged to remember true meaning of 'core' in fixed income
Amid growing signs of receding inflation, the inverse stock-bond correlation that defined the balanced portfolio is set to make a comeback. But given the state of rates today, advisors looking to adopt the 60-40 formula once more must also shed a critical bias built over more than a decade.
“I think what's really been evolving a lot since the Goldilocks, post-GFC world of QE has been the changing nature of correlations between bonds and equities,” said Hafiz Noordin, vice president & director at TD Asset Management Inc., during Wealth Professional’s recent Advisor Connect event on fixed income.
Last year, investors were staggered as both public equities and fixed income markets declined to end the year in deep negative territory. With record inflation and surging interest rates both manifesting in full force, valuations for both asset classes plunged in short order.
“[Bonds having a] negative correlation to equities … that wasn't the story in ‘22 because the rate suppression [by central banks] ended in ’22,” said James Dutkiewicz, SVP and head of Fixed Income, CI Global Asset Management. “The beach ball is no longer submerged under the water, and it's popped up.”
As the idea of inflation ebbing this year starts to take hold, Noordin said hopes of a return to the traditional inverse dynamic between bonds and equities – with stocks doing well when bonds don’t, and vice versa – are on the rise.
“I’d suggest that medium-term, that will be true that bond yields will provide that shock absorption, especially if we do get into a ‘hard landing’ scenario,” he said.
For even the most seasoned prognosticators, it’s still exceedingly difficult to read the economic tea leaves. Inflation is slowing, but remains at an elevated level far above central banks’ neutral target of 2% to 3% per year. Labour market figures point to continuing strength in the Canadian economy, though Noordin acknowledged there are pockets of risks that introduce downside skew to the growth outlook. To the extent that those mixed signals persist, he said, correlations between bonds and stocks will remain challenging.
“Given that we're towards the end of this cycle, I do think that fixed income will provide that negative correlation [to equities] that you need in a portfolio that we didn't get last year,” Noordin said.
Even if the market does return to the old seesaw relationship between equities and bonds, Dutkiewicz said, a lot of advisors will find it hard to forget the decade-plus of financial repression that made government bonds – which will represent 50% to 70% of the traditional core Canadian or core global bond fund by assets at different points in time – “the pariah of any portfolio.”
“You now would have negative correlation to equity prices, but not if you think a core bond fund is an investment-grade portfolio, or a fund that owns high-yield [bonds] and REITs,” he said.
Those alternatives to government bonds, he said, were borne out of investors’ need to reach for yield over the past 12 years as government fixed-income rates were so anaemic. In the classical sense, he said they should not be part of a core bond fund, and that advisors who do make them part of their fixed-income core should understand the risks they’re taking.
Within a pre-GFC 60-40 portfolio, he said the 40% fixed-income sleeve would have had 30% of its assets in a plain-vanilla core fund, with the rest being sprinkled across various other fixed-income exposures with differentiated risks. Given today’s interest rates, he said, the traditional core bond fund should be able to exhibit the same allure it did in the earlier aughts.
“At these yield levels on your traditional product, you can make a very good argument that your 60-40 portfolios still make sense, and that 30% of that 40 should be in something that is negatively correlated to risky assets,” he said.