There have been few hiding places for investors in 2022 and to make matters worse, bonds which have historically provided some protection, have clocked up double-digit percentage losses.

This means traditionally conservative 60/40 portfolios, a bedrock of many retirement pots, have suffered losses for the first time since 2008.

The Bloomberg 60/40 index is down around 10% year to date while the Vanguard LifeStrategy 60% Equity (B3TYHH97) has also lost 10% of its value.

Surging inflation and rapid increases in interest rates have been a toxic mix for fixed income investors generally. The Bloomberg Global Aggregate Bond index is down 20% year-to-date.

The pain has spread to other asset classes which have historically provided stable income and diversification benefits such as REITs (real estate investment trusts) and infrastructure funds.

The last few months have shown that financial markets can be very unpredictable which underlines the importance of having a long-term perspective.

WHAT ARE LIFESTYLE FUNDS?

Lifestyle funds provide investors with a ready-made investment plan based upon their age. At the younger end of the age spectrum, portfolios are constructed with a higher weighting in equities to exploit their higher growth potential.

As individuals approach retirement a greater proportion is moved into bonds which historically have provided more stable, but lower returns than equities. The idea is to lessen the impact from a sharp fall in equities close to retirement.

Since the 1980s 60/40 portfolios delivered returns on a par with equities but with less volatility or in other words a smoother ride. This is often referred to as a ‘risk adjusted’ return. An asset which offers a similar or better return with lower risk has a higher risk adjusted return.

WHY HAS 60/40 BEEN SO SUCCESSFUL?

In the early 1980s the US Federal Reserve managed to stamp-out high inflation which allowed bond yields to fall (yields fall when prices rise). Because equities are often valued using risk-free interest rates, when they fall, the theoretical value of equities increase. This in turn leads to higher PE (price to earnings) ratios.

One of the key reasons for the past success of the 60/40 strategy is the low or negative correlation (relatedness) between bonds and stocks. During times of stress investors prefer the safety of bonds and sell stocks while in good times they do the opposite. This ballast effect reduces losses in bad times and smooths longer-term returns. Until the last 12 months, this relationship had been consistent for a long period.

SHOULD INVESTORS ABANDON 60/40?

Investors shouldn’t necessarily abandon 60/40 argues Morgan Stanley’s head of analytics and cross-strategy Steve Edwards. While a 60/40 portfolio may offer lower returns than in the past, it doesn’t mean it will stop working.

Edwards says: ‘Indeed, the 60/40 portfolio may continue to deliver solid risk-adjusted returns. Bonds likely remain good diversifiers for stocks, helping to dampen the effects of volatility, even if they don’t offer the same degree of diversification as they did before.’

A recent Bloomberg MLIV Pulse survey taken between 8-12 August suggest investor appetite for 60/40 is still strong. Respondents were asked, ‘Over the next 10 years, do you expect the 60/40 portfolio to provide returns on average above inflation?’

Perhaps surprisingly, over two thirds of professional investors and 60% of retail investors voted yes. Not all professional investors agree. Investment managers Edward Donati and Ajay Johal at specialist asset manager Ruffer argue more pain could be on the cards for 60/40 investors if inflation remains stubbornly high.

The managers point out that between 1970 and 1975 a 60/40 portfolio lost 60% of its value when adjusted for inflation. They comment: ‘In a market regime change, in which equities and bonds fall together, investors will need an asset with low correlation to these markets, and negative correlation at points of stress.’

HOW COULD 60/40 BOUNCE BACK?

There are valid arguments on both sides of the inflation debate. The key thing to appreciate is that nobody really knows how the current economic situation will play out due to its uniqueness. For investors who have already suffered the pain it might be worth sitting tight. After all, bonds now pay a higher yield than they have done in over a decade.

‘Fixed income absolutely earns its place in a portfolio now because it actually has income’, says Schroders’ (SDR) head of US Multi-Sector Fixed Income Lisa Hornby.

The latest UK GDP data showed the economy is already in recession while fears of a US recession have been building for weeks. With central banks fixated on fighting inflation, the risk of a deeper recession remains a possibility.

Bonds have historically performed well during recessions as interest rates fall (prices rise). The key unknown factor for bond investors and 60/40 portfolios this time around is how quickly inflation falls in such a scenario.

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