People invest in fixed income for many reasons. I would argue that the three most popular are (1) income, (2) low volatility, and (3) inverse correlation to equity returns.
Reasons 1 and 2 tend to be why you see a portfolio skew towards fixed income as investors move from their accumulation to their withdrawal phase: they supplement their income with very little risk to their principal. Well, at least in the last 30 years.
But I’m not here to talk about rising rates. I did that in my last post. Right now I want to talk about the phantom return booster that everyone is forgetting as we discuss rising rates — the only free lunch in the market — yes, that’s right: diversification.
Stocks and bonds (U.S. treasuries, at least), have exhibited a strong negative correlation for many years and that negative correlation has been the foundation that many portfolios have been built on. The negative correlation allows us to take advantage of diversification, allocating a greater portion of our portfolio to equities to collect the equity risk premium, but maintaining a dampened volatility level. In quantitative terms, correlation measures the linear similarity between time-series variation; both securities can still have positive means but be negatively correlated.
Interestingly, both 30-year and 10-year constant maturity portfolios (proxied by TLT and IEF, respectively), have shown the same correlation to equities over the last decade.
To demonstrate the value of this hedge, in the graph below I plot risk-parity portfolios of the S&P 500 (proxied by SPY) and different fixed income portfolios. To truly highly the value of diversification, I use my crystal ball to perfectly predict forward volatility and inversely weight each asset based on their volatility, making sure each asset contributes the same amount of volatility to the overall portfolio.
What we see are the benefits of diversification at play: reduced volatility and drawdowns. We also see a nice relationship at play: we can choose our risk level via the fixed income instrument we choose to hedge with. Since 30-years have a higher duration, they have higher sensitivity to interest rates and therefore greater volatility — making them a better hedge and also commanding a greater premium than the 10-years. This means that we need less of the 30-years to hedge the risk of the S&P 500, allow us to capture more of the S&P’s premium over time. If we want less volatility, though, we can step to the 10-years.
And I am starting to get the feeling that this is the picture that a lot of people have as they start worrying about rising rates and duration risk. “Oh, I’ll just step down the ladder a bit,” they say.
Consider the next graph.
This image takes the returns of TLT and IEF and negates their correlation to SPY, now giving them positive correlation (technically, the process was to de-mean the log-return time-series, negative the remaining residual, and re-add the mean). This is the dangerous future: despite the fact each security is contributing an equal amount of volatility to the portfolio, diversification is gone and we can no longer safely allocate a larger portion of our portfolio to equities to collect the equity premium without taking on more risk.
Now, technically TLT and IEF still offer some diversification benefits, as they are not perfectly correlated — but not nearly the way they used to. No free lunch here. Do not pass Go! Do not collect $200!
The summary statistics of the different strategies tell the story:
Reduced returns, increase volatility and increase drawdowns. Not a pretty future.
An asset allocation is not a risk profile. If the dramatically changing volatility and tail-risk profile of a 60/40 over the last decade didn’t highlight that, I hope this analysis did. At Newfound, we believe in flexible solutions that adapt to evolving market cycles. If diversification is available, we should exploit it for as long as possible to capture as much of the largest available risk premium as we can. But we also need a plan B, in case diversification as we know it disappears. We need to define our risk profile beyond an asset allocation and start thinking about our portfolios in terms of meeting objectives — at the very least, define them in terms of tolerable drawdown. In this way, we can flexibly change our allocations as diversification ebbs and flows into the market place to create a consistent risk profile.