By Erich M. Hickey, CFA® and Terrance Rebello, CFA® and CIPM

Since 1981, when the 10-year U.S. Treasury yield peaked at over 15%, investors have enjoyed the benefit of holding Treasury bonds in their portfolios. Longer-maturity Treasuries have been the perfect complement to equities. Over a full market cycle, Treasuries and equities have been positively correlated, with each producing attractive positive long-term returns. Also, in almost every period in which equities have declined since 1982, U.S. Treasuries have been negatively correlated in the short term and provided an offset to temporary equity losses. Portfolios with

60% to 70% in global equities and 30% to 40% in investment-grade bonds have produced attractive risk-adjusted returns for close to 40 years. History, however, is unlikely to repeat itself in the coming decade. The 10-year Treasury now yields under 0.75%, so future price appreciation will be limited unless yields move sharply negative. Also, investors will receive virtually no income to offset price declines if yields move higher. With the risks seemingly skewed to the downside, should we abandon bonds in our portfolios?

The short answer is no. Bonds still diversify equity risk, provide liquidity and generate income. Return expectations must be adjusted, but fixed income will continue to play an important role in portfolios. Also, bonds can serve as an emotional hedge for investors. By controlling portfolio losses in adverse equity markets and ensuring liquidity is available for cash needs, an allocation to bonds can create peace of mind and avoid irrational, emotional decision making in times of crisis.

Long-dated Treasuries are an attractive “hedge” to an equity portfolio. For example, the 30-year Treasury bond appreciated over 20% in the first quarter of 2020, while the S&P 500 declined 19.6%. While Treasuries are not a perfect hedge, during most sharp equity corrections in the last 20 years, U.S. Treasuries have rarely declined and have often appreciated materially. Treasury yields rarely increase sharply, which lowers the cost to investors for owning these assets in their portfolios. We also believe that Treasury yields are unlikely to increase materially during an equity sell-off, which means government bonds should continue to act as a hedge during market turmoil.

Second, Treasury bonds can be converted to cash to meet liquidity needs. As we experienced in March, sometimes pricing may be adversely affected in a crisis, but the impact of these price concessions was considerably lower than the impact of selling other risky assets.

Third, there are many other types of bonds that have higher yields than Treasuries and can be used to generate income in a low-rate environment. In order to earn a higher yield, investors will take on different risks, including liquidity risk or credit risk. We recommend discussing the potential downside of these bonds with a financial professional before considering these securities in a portfolio.

How much should I allocate to fixed income?

The size of your total fixed-income allocation will vary depending on your individual risk tolerance, liquidity needs, income needs, liabilities, objectives and assets that you hold outside of your liquid investments. Most of these items should be included in your investment policy statement and reviewed at least annually. For business owners, we account for their businesses in their overall asset allocation. This exercise includes assessing profitability, reviewing the capitalization of the business and reviewing current credit agreements. More importantly, if the operating business is cyclical, leveraged or growing rapidly, we encourage owners to consider potential liquidity needs under more draconian assumptions and recommend a larger allocation to fixed income. Earlier this year, we learned how difficult it may be to access cash, so planning ahead can prevent the need to sell depreciated assets for liquidity.

For foundations committed to maintaining their spending policy, liquidity is also paramount. We recommend having two years of operating and funding requirements available in conservative fixed-income strategies. This will ensure your foundation can meet its commitments to its grantees and continue operations without disruption. It also creates peace of mind.

What should my fixed income allocation look like?

With yields close to 0%, we separate our fixed income allocation into three parts: liquidity assets, risk off hedges and total return assets.

Liquidity assets: In general, we recommend keeping at least one or two years of cash needs in shorter-dated bonds, including Treasuries and other investment grade bonds. The prices of these securities will have a negligible sensitivity to interest rates and price movement should be modest. One drawback is that current yields are near 0%. In our opinion, having some allocation to cash-like securities without the risk of loss overshadows the opportunity cost of losing potential return by taking on more interest rate or credit risk.

Risk-off hedges: As we highlighted, longer dated Treasuries represent an attractive “risk-off” hedge at the lowest price. Include longer maturity bonds in allocations as an “anchor to windward.” This part of the portfolio is designed to preserve capital when other assets decline in value. Appreciated hedges can be sold to rebalance into equities or for liquidity needs.

Total return assets: We allocate a portion of our fixed-income portfolios to strategies that offer higher yield or total return potential. These strategies generally have less liquidity and more

credit risk but tend to be less correlated to equity markets and interest rates. In the current market, certain securities that were excluded from the Federal Reserve Quantitative Easing Programs have been orphaned by investors and offer high yields and attractive total return potential.

The most significant determinant of future returns for fixed-income assets is the starting yield. Less risky bonds are currently at or near all-time lows in yield, so future returns will be likely be meager. Given the low expected returns, we do not advocate abandoning your allocation to fixed income in your liquid portfolios. Bonds serve numerous purposes in a diversified portfolio, and while the tailwind from a near 40-year secular decline in interest rates is gone, bonds should still perform well during future equity market crises. We recommend reviewing your portfolio to ensure you understand what you own and why it is a part of your fixed-income allocation.

Erich M. Hickey, CFA, and Terrance Rebello, CFA, CIPM