Reducing Portfolio Risk (Bonds?) in a Zero Interest Rate Environment

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Reducing Portfolio Risk (Bonds?) in a Zero Interest Rate Environment

Typically, the majority of risk in a balanced portfolio resides in the equity portion of the portfolio. According to Alpha Simplex, virtually all of the risk in a 50/50 portfolio comes from equities and a whopping 82% comes from equities in a portfolio with just 30% of its assets in stocks and 70% in bonds. Risk mitigation has traditionally involved increasing the allocation to bonds due to their inherent lower volatility, steady income streams and low correlation to equities.

But now that bond yields have fallen to historic lows, bonds are increasingly seen as vulnerable to ceding their role as portfolio stabilizers. Before you rush to sell all your bonds, however, please be warned that pundits of all stripes and pedigree have declared the bond market to be dead and buried for years now. Rumors of the death of bonds, of course, have been premature…and then some. And they may well continue to be premature, as the Fed has declared that they will do what they can (which is a lot!) to keep both short and long rates very, very low. As well, no one’s crystal ball can definitively say that we have left the financial crisis completely in the past, and therefore we would not recommend shorting bonds without a strong stomach! Hardly a no-brainer!

But let’s re-examine a few of our reasons for owning bonds. Yes they are less volatile, even in a rising interest rate environment, no question. What about the steady income stream? Yes, steady but a bit low. When bond yields are at 5%, they are adding to total return and reducing volatility. Part of what reduces volatility is the yield offered and at today’s lower yields, bonds are mathematically more volatile, all things equal. And of course the income is less than overwhelming. What about the low correlation to equities? If equities crash due to an unexpected renewal/continuation of the financial crisis, yes bonds will go the other way and will reduce portfolio volatility. But what if rates begin to go up as the economy improves (assuming we have crossed under the Fed’s benchmark of 6.5% unemployment)? Could higher rates have a negative impact on the stock market?

More investors are beginning to look at the bond portion of the portfolio as a source of risk and are trying to decide whether to move more into equities. Without a “view” on the stock market (or a fully functioning crystal ball), I’m not sure these investors are reducing risk, however, as stocks are inherently more risky. This amounts to a market call, which most investors declare they do not want to make. It is another example of the Fed’s policy of financial repression pushing people out on the risk curve.

Other investors have been making more modest trade-offs of risk and return, diversifying into high yield bonds, preferred stock, bank loans, master limited partnerships, commodities and Treasury Inflation Protected securities. While equity risk is embedded in some of these asset classes, the higher standing in the capital structure mitigates that risk. Others are shifting into other diversifying strategies which emphasize dynamic management of risk factors, allocating funds across a broad spectrum of asset classes and risk factors. The dynamic aspect of these strategies is vital as we continue to navigate through uncharted waters. Investors in the traditional mold of buy, hold and re-balance would be well served to take a closer look their portfolio, particularly from the perspective of risk management.

About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM

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