The Bond market is in crisis. The last 2-3 year market dynamics are challenging the effectiveness of the traditional "balanced portfolio model" comprising in general of a 60/40 Equity/Bond allocation, a model that has stood the test of time in manging risk and equity market cycles. In a close to zero interest rate climate with high inflationary risk, the investment rationale for holding bonds is now being called into question.
Let's dive a little deeper into the issue with a two part article. The first part looks at what is happening in the Bond market and the second part which we will publish mid-week will look at the trends in the bond market in 2020 and 2021 and what the elite of the investment world are saying about it.
What is happening with Bonds and Why?
The traditional balanced potfolio model set a portfolio ratio of 60% Equities and 40% bonds. This ratio might change depending on your age. In other words as you get older your ratio of bonds might increae and conversely if you are younger you may increase the equity side of the ratio. The rationale for this model is that as equity markets go through their inevitable bull and bear market economic cycles you can offset risk by having a percentage assets in bonds. Bonds were always a conservative investment promising a high likelihood of return of capital. If interest rates rise you get more income whereas if interest rate fall, bond prices increase offsetting any interest you may have lost as a result. A traditionally balanced portfolio mitigates for equity market volatility and provides risk adjusted access to capital as needed.
In the current economic environment however with interest rates at historic lows you have a different set of risk/reward parameters. As interest rates have little to no room to fall further there is likewise little room for bond price appreciation. If interest rates rise, bond prices may fall more in proportion to the additional interest yield. Furthermore, when you add in the additional inflation risk due to the enormous stimulus and QE (quantative easing) enacted duing the COVID crisis, you have another negative for holding bonds which is that the risk of "return of capital" may very well not cover the inflationary risk adjusted returns. The current climate for bonds is not favorable from a risk/return perspective.
We will post part two of this article by Wednesday next week.
We hope you enjoy your weekend!