In Focus: Fixed income  

The 60/40 portfolio is not dead yet

David Henry

David Henry

One reason investor sentiment is currently so negative is that both the main asset classes investors use to construct portfolios are down for the year. 

Bonds tend to go up when equities fall, and vice versa. That is portfolio construction 101.

When people are fearful about the future and do not want to take on risk through holding company stocks, demand for the relative safety of a fixed income increases.

This is usually the case, but the fly in the ointment this year has been inflation. If rising inflation has not historically been great for stocks, it has been a disaster for bonds. Particularly when the starting income offered by bonds is basically non-existent, as was the case this time last year.

Bonds vs equities (Source: Refinitiv Datastream)

In 2021 we mainly had inflation in the cost of stuff – cars, garden furniture, fridges. This year, it is inflation in the cost of fun, as we all emerge back into the wild after lockdown.

This inflation ravages the real value of a loan to the UK government that pays you a flat annual 0.5 per cent, as a 10-year gilt did this time last year.

That is miles behind the current inflation rate of around 10 per cent, so it is only natural that investors will need a higher return to try and get closer to the current rate of inflation – in which case the price of the bond falls.

So, if investors want to rebalance their portfolios in light of the fact that the two main components of their asset allocation are down for the year, then what do they buy?

Commodities have been the standout performer year to date – should we be looking to alternatives in the current climate?  

Many commentators have been decrying the death of the classic 60/40 equity/bond portfolio of late – however, looking back through history suggests this conclusion may be premature.

Going back to 1986 we looked at quarterly returns for stocks (MSCI World, the global stock market) and bonds (gilts, loans to the UK government).

While over longer time periods bonds and stocks tended to move in different ways, there were nine quarters when the prices of both bonds and stocks fell in tandem.

It has happened only once since 1986 in consecutive quarters: Q1 and Q2 2022. Breakdowns in diversification, like we have witnessed this year, are rare.

We then looked at 12-month forward returns for this 60/40 asset allocation following quarters where stocks and bonds fell together. As you can see from the below, performance was relatively healthy.

Quarterly period

1Y total return in 60/40 portfolio post quarter

Q1 1990

10.3%

Q2 1994

8.3%

Q3 1999

15.5%

Q2 2006

7.8%

Q2 2008

-4.0%

Q1 2009

25.4%

Q2 2015

14.5%

Returns are shown for a 60% MSCI World/40% iBoxx Gilt Portfolio (Source: Quilter)

One benefit of having a disciplined approach to investing is, in theory, it leaves you less predisposed to following a narrative.

Increasing enthusiasm about whatever asset class or sector is working at a given point in time means that it can feel like it is going to work forever.