Bonds For “Diversification”? Not So Fast.


“You keep using that word. I do not think it means what you think it means.” 

  • Given the current Fed backdrop along with the historic decline in interest rates over the last few decades, fixed income investments cannot be expected to play the same role they have traditionally
  • Simply put, the perceived benefits of diversification generally expected from allocating to fixed income when constructing portfolios do not look likely to play out as they have in the past
  • To address this change in expectations, protective investments—such as structured notes—may be an effective addition to portfolios

A decade-plus of Fed tinkering has turned conventional money management on its head. U.S. Treasury rates are flirting with zero nominal yields and 2020 even saw negative real yields on T-Bills. Fixed income—the backbone of cash flow, risk management, diversification, and safety— has been completely upended. 

The ongoing run of the longest bull market in history has not helped investors face reality: fixed income allocations cannot perform as investors have come to historically expect.

Bonds as a Ballast

The classic balanced portfolio has come to be known as “60/40”: 60% equities, 40% fixed income. Over the past few decades, investors who used this strategy were rewarded, due in large part to the meaningful contribution of bonds over this period. There are several reasons for this:

  1. For opportunistic investors, steady yield declines have resulted in significant price gains. (Remember, bond prices rise as yields decline);
  2. Although declining as yields fell, coupon income has buoyed total returns while also helping to satisfy cash flow demand;
  3. Historically, when equities have jumped out of line, bonds have provided some level of risk hedge, hence their use as portfolio ballast.

However, in response to the financial crisis of 2008 and, most recently, COVID-19, interest rates remain well below historical norms. After several decades of ever-declining rates, it may be unrealistic to expect fixed income to offer the same risk-reward profile that it has in the past.

This Time Is Different

Michael Lebowitz, CFA, of Real Investment Advice offers an interesting framework to illustrate the equity-hedging benefits of holding bonds during the prior two recessions. The COVID-19 recession (which officially lasted only two months in the U.S.) is ignored here.

For simplicity’s sake, let’s assume investors used a classic 60/40 strategy with a 40% fixed income allocation to 10-year U.S. Treasuries. In the two prior recessions, the 40% bond allocation would have limited downside deviation as follows:

  • From September 2007 through March 2009, a simple 60/40 (S&P 500/7-10 Yr. UST) portfolio returned -23.92%. An all-stock portfolio returned -45.76%. The 40% allocation to bonds reduced losses by 21.84% (M. Lebowitz, as of 4/22/20).
  • From January 2000 through September 2002, a simple 60/40 (S&P 500/7-10 Yr. UST) portfolio returned –16.41%. An all-stock portfolio would have returned -42.46%. The 40% allocation to bonds reduced losses by 26.05% (M. Lebowitz, as of 4/22/20).

Most significantly, heading into these two bear markets, the 12-month average yields on 10-year U.S. Treasury bonds were 6.66% in 2000 and 4.52% by late 2007. At their lows, the yields fell to 3.87% and 2.43% in 2002 and 2008, respectively.

The charts below highlight the decline in yield for the 10-year Treasury note, as well as the approximate cumulative total return (price plus coupon) over the recessions mentioned above.

This example demonstrates the significant benefits bonds have recently provided investors. However, the previous two bear markets began with interest rates at materially higher levels than we see today


On August 31, 2021, the 10-year UST rate closed at 1.30%. Historically, 10-year Treasury notes yielding 4% or 5% have partially offset equity losses. But with 10-year yields hovering just above 1%, down significantly from prior market selloffs, there is limited room for price appreciation owing to the decline in yields over the past two decades.

To drive this point home, consider: if bonds were to provide 25% protection as they typically have in the past,10-year Treasury yields would have to fall significantly into negative territory, as they did in Europe and Japan. That said, it remains unlikely the Fed would do the same in the United States.

Regardless of where rates head from here, the historical benefits of diversification generally tied to fixed income simply do not look to play out as they have in the past.

So, where do investors go from here?

Protective Investments & Structured Notes as an Alternative to Traditional Fixed Income

As a bond hybrid investment, structured notes may offer some compelling characteristics. They are capable of offsetting some of the diversification benefits lost to conventional fixed income securities in a seemingly perpetual low-rate environment.

For example, should the Fed continue to take a hawkish tone, equity-linked structured notes could serve as an effective late-cycle addition to balanced portfolios. By all accounts, it looks like rates are going higher as we move into the fourth quarter. Reallocating from conventional fixed income to a protective investment such as equity-linked structure notes allows investors to trade interest rate/duration risk for a combination of credit risk and equity exposure in a familiar investment package.

Structured notes are not suitable for all investors. Each has its own set of risks and considerations. However, should traditional fixed income’s utility as portfolio “ballast” continue to disappoint, investors may find better results using protective investments such as structured notes for portfolio building blocks.

By taking advantage of these unique characteristics, structured notes may generate new risk-return profiles and outcomes otherwise unavailable with traditional 60/40 asset allocation portfolios.

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An investment in structured notes may not be suitable for all investors. These investments involve substantial risks. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. This material does not provide individually tailored investment advice, nor does it offer tax, regulatory, accounting or legal advice.

Hypothetical performance results have inherent limitations. There are frequently sharp differences between hypothetical and actual performance results subsequently achieved by any particular trading strategy. Hypothetical performance results do not represent actual trading and are generally designed with the benefit of hindsight. They cannot account for all factors associated with risk, including the impact of financial risk in actual trading or the ability to withstand losses or to adhere to a particular trading strategy in the face of trading losses. There are numerous other factors related to the markets in general or to the implementation of any specific trading strategy that cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. Any estimates and projections (including in tabular form) given in this communication are intended to be forward-looking statements. This should be used for informational purposes only.

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