Why diversification in your portfolio still matters

Rewind to the beginning of 2022, the labor market was strong and inflation had crept to a 40-year high. Expecting it to be transitory, the Federal Reserve Board hiked the fed funds rate 25 basis points, believing that would be enough to keep inflation at bay. Fast forward to present day, the labor market is holding steady, and since that first hike, the Fed added (to date) another 425 basis points to the rate in an effort to stifle inflationary pressures.

It would have been hard to predict such a precipitous turn of events in the market, and bonds reacted the way bonds do when interest rates rise: their prices fell … sharply. In fact, 2022 was intermediate bonds’ worst-performing year since 1926, while long bond losses broke a 250-year record, according to a well-circulated analysis by Edward McQuarrie, professor emeritus at Santa Clara University.

The negative returns in stocks and bonds had investors questioning the wisdom of having a 60/40 portfolio, but it was never about the 60% (i.e., stocks). It was about the suitability of having 40% of an investor’s assets in fixed income in light of the low interest rates and expected returns from fixed income.

Consider that at the beginning of 2022, the yield on the 10-year Treasury was 1.75% and just over a year later, the yield is 3.9%. The rise in yields occurred throughout maturities, with the short end seeing the most increase due to the Fed’s aggressive rate hikes. Meanwhile, corporate debt is yielding even higher as investors are paid a spread over Treasurys to take on additional risk since they are backed by the corporation and not the U.S. government.

Still, bonds offer diversification to stocks, and it is rare to have stocks and bonds deliver negative returns in a given year — happening only two other times: 1931 and 1969. (It is less rare for it to occur on a quarterly basis, with 37 such occasions in 96 years. However, it’s only come to pass nine times since 1990.)

Yields at these levels also dampen the potential blow of further increases to interest rates. The Bloomberg US Aggregate Bond Index (Agg) is now yielding 4% with a duration of 6.3 years, and for the Agg to deliver 0% return, for example, rates would have to increase another 63 basis points. Due to the inverted yield curve, investors can likewise take less interest rate risk by investing in shorter-term bonds which are similarly yielding 4%-5%. A mix of different maturities can lower interest rate risk, while combatting against reinvestment if short-term rates go lower due to potential fed funds rate cuts in the future.

Over the short term, it’s difficult to determine what will happen, especially in view of a potential recession, history tells us it shouldn’t get much worse for bonds. Rather, they should soon be back to what they do best in a portfolio, which is balancing out the typically more volatile stocks.