Much Ado About Bonds

I don’t own any bonds.

I doubt I ever will.

My small bond allocation is in short term treasuries (if you call those bonds then yes I own bonds), but they basically yield me zilch (my advisor Charlie handles this for me). Charlie and I have spent the last year thinking through portfolio construction for clients in a world of zero and negative interest rates and I can’t recommend bonds in this interest rate environment.

Rates in many countries around the world have gone negative and interest rates in the USA seem headed that way.

Last week, Warren Buffett chimed in on the negative interest rates with a confused warning. Make sure you listen to it.

If you have a financial advisor you have likely been pitched a simple 60/40 portfolio which means 60 percent equities and 40 percent bonds. Institutional Investor does a pretty good job of explaining why this might be an outdated strategy. The gist:

Despite the longest economic expansion in U.S. history, the gap between the present value of liabilities and assets at U.S. state pensions is measured in trillions of dollars. To make matters worse, pensions are now faced with the reality that standard diversification — including extremely low-yielding bonds — may no longer serve as an effective hedge for equity risk.

While I was at CalPERS, concerns arose in 2016 about the effectiveness of standard portfolio diversification as prescribed by Modern Portfolio Theory. We began to recognize that management of portfolio risk and equity tail risk, in particular, was the key driver of long-term compound returns. Subsequently, we began to explore alternatives to standard diversification, including tail-risk hedging. At present, the need to rethink basic portfolio construction and risk mitigation is even greater — as rising hope in Modern Monetary Theory to support financial markets is possibly misplaced.

At the most recent peak in the U.S. equity market in February 2020, the average funded ratio for state pension funds was only 72 percent (ranging from 33 percent to 108 percent). That status undoubtedly has worsened with the recent turmoil in financial markets due to the global pandemic. How much further will it decline and to what extent pension contributions must be raised — at the worst possible time — remains to be seen if the economy is thrown into a prolonged recession.

A considerable body of evidence shows these funding problems are connected with how most pension portfolios have been constructed for more than a decade. Without changing the approach, it seems unlikely that funded status can be improved in the coming decade through investment performance alone.

I focus on a typical passive benchmark consisting of a 60 percent allocation to the Standard & Poor’s 500 Index and a 40 percent allocation to the Bloomberg Barclays US Aggregate Bond Index to illustrate the shortcomings of standard diversification since the global financial crisis of 2008 (GFC). Public pensions funds have steadily increased the allocation to alternative assets including private equity and real estate — reaching at present an average allocation of 28 percent to these investments. This overdiversification has only made matters worse. A recent paper by Richard Ennis shows that 46 public pension funds have underperformed a passive benchmark by about 1 percent per year in the period from July 2009 to June 2018. CalPERS, the largest U.S. pension, ranks near the bottom, underperforming by 2.36 percent.

The traditional 60/40 mix of stocks and bonds, commonly portrayed as an optimal portfolio, is supposed to mitigate the effects of this sort of extreme market volatility and deliver returns that pension fund managers can rely on. But the 60/40 mix is an artifact from another time. The optimal mix presumes it is possible to achieve a high rate of return while simultaneously constraining volatility. In practice, it limits portfolio volatility in benign market environments over the short term while making huge sacrifices in long-run performance. The so-called optimal portfolio is, in effect, the worst of all worlds. It offers scant protection against tail risk and, at the same time, achieves an under-allocation to riskier assets with higher returns in long periods of economic expansion, such as the past decade.

Feel free to hit me up if you have concerns and I am happy to introduce you to Charlie and he can explain some of the ways we are thinking about portfolio construction in a zero interest rate world.


Also published on Medium.