Over the last twenty years, asset allocators, balanced fund managers, risk parity adherents and millions of Americans have come to rely on long-term government bonds as a beautiful soulmate to equity holdings. I fear those days are coming to a screeching halt. With long-term government bond yields now below 0.8%, allocators need to face the reality that an asset class that was once 40-50% of their portfolios, will now produce a guaranteed negative rate of return before taxes and fees. There is no longer any rationale for your classic balanced fund.
Since 2000, long-term government bonds have done three things incredibly well in portfolios:
1. They have been a credit-riskless asset. So, through recessions, crises, and scares they occupy a core spot in the portfolio.
2. They have been consistently negatively correlated to stocks (stocks up, bonds down and vice versa). In fact, the negative correlation is significant, and the beta is -0.2. The combination of stocks and bonds has created efficient portfolios that maximized return-per-unit of risk.
3. They have provided great returns. The total return for 20 years is almost 300%.
But now peering into the crystal ball for the next 20 years it is decidedly murkier. I’m sure #1 isn’t changing any time soon, but as we run more and more massive deficits with trillions of unfunded obligations, perhaps you can hear the pipes starting to clang. As for the correlation, it is not likely to get more uncorrelated because it sits near all time lows but, I don’t think the correlations will swap to positive until we get inflation. And, thank you Coronavirus, that’s not realistic this year.
So why the warning on the end of long -term government bonds in a classic balanced portfolio?
Bonds will not provide returns anymore like they have for the last 20 years. First, let’s say you buy and hold. The market’s inflation expectation for the next 10-yrs is 1.3%, and it’s 1.5% for the ten years after that. Starting at 0.75%, you are expecting a significant negative real yield. Moreover, some of us pay taxes and fees. Ouch. Maybe you expect that we get significant economic weakness and lower inflation. Couldn’t it work out then? Here are the facts, so you decide: For those long-government bonds to give us that same 300% total return looking ahead 20 years, the bonds would have to drop to a yield of -22%!! I am safer predicting a zombie apocalypse or aliens.
So, reluctantly I begin the separation from a beloved dear friend: I am recommending eliminating government bonds from our asset allocation funds. The valuation is no longer there, so take the profits on 1/3 of your position right away. Perhaps, the next third comes as sentiment swings from ecstatic about bonds to euphoric. That could happen soon. And finally, exit entirely after the first glimmer of economic rebound post virus. Right now, it looks like Q2 will be the earliest that could happen. What to do with all those proceeds? Here’s the tease – a portfolio that beats cash and is uncorrelated or negatively correlated to stocks. More on that next week.
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