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Rethinking Asset Allocation

What do higher bond yields mean for asset allocation?

November 2023

This article appeared in The FM Report on 23rd November 2023.

After an AI-propelled surge in equities this summer, the change in seasons has brought choppier conditions to financial markets. In Q3, attention shifted from stocks to bonds as concerns developed about rising debt levels in major economies.

Across developed markets, government bond yields reached their highest levels in well over a decade bringing the mark-the-market declines on many long duration bonds to more than 50%.

Since then bonds have stabilised but sentiment remains cautious and the implications of the sudden change in yields for asset allocation may be far-reaching.

Asset allocation in the era of cheap money

Just two years ago investors were still bemoaning the trillions of dollars of government bonds that had negative yields. A decade of sluggish economic growth, low inflation and central bank quantitative easing had driven government bond yields below zero in many countries.

Negative yields made government bonds uninventable for many investors by effectively guaranteeing a loss for anybody buying and holding bonds to maturity.

But the era of quantitative easing and low yields had other notable effects on asset allocation.

  1. They helped spawn a sentiment of TINA – “there is no alternative” to equities.

  2. Asset purchases by central banks contributed to lower yields but also injected liquidity into financial markets which flowed into everything from high growth stocks to crypto.

  3. Private equity and long duration assets became much more attractive given that low yields meant future cash flows were not so heavily discounted and leverage was almost zero cost.

Debt sustainability

While negative yields were a headache for fixed income investors, they were a boon for policymakers when COVID struck by enabling an enormous fiscal response. However, the US has continued its fiscal expansion under Bidenomics, resulting in escalating fiscal deficits.

In fiscal year 2023, the US ran a federal deficit of $1.7trn, over 6% of GDP. That would not be unusual in a recession (when tax receipts are lower and social welfare payments are higher) but is unusual for an economy at close to full employment.

US Federal Deficit as a Percentage of GDP

Investors and the ratings agencies have started to take note. On August 1 Fitch downgraded US sovereign debt from AAA to AA+. Hedge fund manager Ray Dalio recently predicted the US will face a debt crisis[1]. The issue is that not only do larger deficits add to the stock of debt but higher bond yields increase the cost of servicing the debt and risk a vicious cycle of rising debt levels if interest rates rise above long term economic growth rates.

Yet, talk of an imminent debt crisis seems exaggerated. Yes, bond prices have fallen dramatically but yields are only back to levels that were once regarded as normal. US 10-year yields are back at 2007 levels. Irish government bond yields are still below the 3.5-6% range they traded in before the banking crisis.

Asset allocation in a higher yield environment

However, It is not so much the absolute level of yields that may be important. It is the abrupt change in yields and the associated change in macro environment which is significant. Higher yields may reflect a structurally changed investing landscape, what legendary investor Howard Marks has labelled a Sea Change[2].

Instead of low inflation, low growth and negative interest rates, we now have higher and more volatile inflation, stronger nominal GDP growth, an end of quantitative easing and higher bond yields.

US 10-Year Government Bond Yields

There are also solid reasons to think that that the secular downtrend in global yields that lasted four decades may have reversed. Structural trends such as the move to active industrial policies, decarbonization and deglobalization could contribute to higher government spending, higher inflation and a greater supply of government bonds which may keep bond yields elevated.

Logic would suggest that the assets and strategies that flourished in the low and stable rate environment (large cap growth stocks, passive investing and private equity) may now encounter challenges, while previously overlooked assets and strategies (like value stocks, commodities, and active trading strategies) may now benefit.

From an asset allocation perspective the changed environment presents a mixed picture for bonds. Higher bond yields translate into higher expected returns. Gains on Irish government bonds are not subject to capital gains tax making them of interest now for Irish investors as a defensive holding within a multi-asset portfolio.

However, historically bonds were always seen as diversifiers for equities. Bond prices tended to go up when equities went down as central banks inevitably cut rates on economic weakness. That negative correlation has reversed recently and may be less reliable going forward. In 2022 bonds and equities fell together and this may be a more frequent occurrence if inflation remains sticky.

Rolling 1-year Correlation between US Stocks and US bonds

If bonds and equities are more correlated, the 60-40 portfolio, the bedrock of many asset allocation plans, will need a rethink. Investors may need to look to alternatives assets and investment strategies to diversify returns.

Real assets and commodities are worthy of consideration for inflation protection. Active trading strategies like global macro, FX trading and trend following have historically fared better in market environments characterised by higher and more variable interest rates and historically have performed well in major equity downturns.

In summary, the change in the rates backdrop has made fixed income investable once again for many investors. But the more significant change may be in the macro investing backdrop which calls for a rethink of traditional asset allocation.

[1] Ray Dalio says the US is going to have a debt crisis,, Sep 28 2023

[2] Further Thoughts on Sea Change, Memos from Howard Marks, Oaktree Capital, October 11 2023

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