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The 40 Don’t Protect



Will Bonds Protect in the Next Bear Market?

Port­fo­lio pro­tec­tion is now top of mind right for many investors.

With U.S. equi­ties push­ing all-time highs, a flat­ten­ing of the yield curve, and the unknown impact of poten­tial trade wars, many investors are jus­ti­fi­ably con­cerned.

Advi­sors usu­al­ly rec­om­mend­ed sig­nif­i­cant bond allo­ca­tions to hedge their clients’ port­fo­lios, and his­tor­i­cal­ly, it has worked.  For exam­ple, dur­ing the most recent bear mar­ket from Novem­ber 2007 until March of 2009, the Barclay’s Bond Index rose 6% while the S&P 500 Index fell 50%. Thus, a bal­anced port­fo­lio of 60% stock / 40% bonds fell around 27%, and a 40/60 port­fo­lio fell only 15%.

But the land­scape has changed.

The envi­ron­ment of low but ris­ing rates presents a chal­lenge to those investors seek­ing pro­tec­tion and cap­i­tal preser­va­tion from bonds.


How Low Can You Go?

Over the last 30 years there have been three times in which the Fed entered an extend­ed peri­od of loose, accom­moda­tive mon­e­tary pol­i­cy in order to help ease the econ­o­my through a reces­sion.  In all three cas­es bonds per­formed admirably well. As rates fell, bond val­ues increased, help­ing off­set loss­es asso­ci­at­ed with the equi­ty mar­kets. If the stan­dard, bal­anced port­fo­lio con­tained 60% in equi­ties and 40% in fixed income, that 40% allo­ca­tion to bonds was vin­di­cat­ed.

Fed Hikes and Recessions - 40 Don't Protect - Swan Insights

Source: U.S. Trea­sury, Zephyr StyleAD­VI­SOR


The pre­vi­ous three reces­sions start­ed with the Fed­er­al Fund rate over 5%.  In each case the Fed was able to cut over 500 basis points from short term lend­ing in order to help boost the econ­o­my dur­ing a reces­sion.  The Bar­clays Aggre­gate U.S. Bond Index per­formed quite well dur­ing these peri­ods, pro­vid­ing pos­i­tive returns that off­set loss­es in the equi­ty mar­kets.

Were a reces­sion to start today with short term rates in the 1.75%-2.00% range, the Fed­er­al Reserve would have much less scope to imple­ment a loose mon­e­tary pol­i­cy. They might push rates back to 0.00%, but the gains to bonds will like­ly be less due to the low­er start­ing point. With less of a val­ue increase, the pro­tec­tion role of bonds is much weak­er than before.


Keeping an Eye on the Yield Curve

Is a reces­sion immi­nent? No one knows for sure. Debat­ing the rel­a­tive strength or weak­ness of the econ­o­my keeps thou­sands of peo­ple occu­pied and gain­ful­ly employed. But one yel­low flag is the recent flat­ten­ing of the yield curve.

Yield Curve - 40 Don't Protect - Swan Insights

Source: U.S Trea­sury


Over the last year the short end of the curve has moved up sig­nif­i­cant­ly, while the long-end has bare­ly budged.  While the yield curve hasn’t yet invert­ed, long time mar­ket watch­ers know this is a bad omen.  For those need­ing a refresh­er on the impor­tance of flat or invert­ed yield curves, the New York Times recent­ly ran this piece in June: “What’s the Yield Curve? ‘A Pow­er­ful Sig­nal of Reces­sions’ Has Wall Street’s Atten­tion.”


Rising Rates Hurt Capital Preservation

Maybe you’re of the opin­ion that the eco­nom­ic expan­sion has room to grow, and you don’t see a reces­sion on the hori­zon. Assum­ing the Fed con­tin­ues on its path of tight­en­ing under healthy mar­ket con­di­tions, the impact on bond prices will be neg­a­tive. As prices and yields are inverse­ly relat­ed, bond hold­ers could feel a lot of pain as rates increased by 3% to their his­toric aver­age lev­els. While this may mean good things for those who want income, it’s a prob­lem for those who are seek­ing cap­i­tal preser­va­tion.

The table below shows the aver­age dura­tions of dif­fer­ent types of fixed income man­agers and how sus­cep­ti­ble they are to loss­es in the face of ris­ing inter­est rates.

Bond Cat Averages - 40 Don't Protect - Swan Insights

Source: Morn­ingstar Direct, Swan Glob­al Invest­ments


We’ve already seen this bear out a bit in 2018, as many bonds have lost mon­ey in the first half of the year.

Rates Increase - 40 Don't Protect - Swan Insights

Source: Morn­ingstar Direct

If rates con­tin­ue to rise in a healthy econ­o­my, bond hold­ers can expect more loss­es.


Rethinking Capital Preservation and the Traditional Portfolio

The cap­i­tal preser­va­tion role hasn’t been tru­ly test­ed in almost a decade, as the mar­ket has not wit­nessed a 20% sell-off since 2007-09. The cur­rent low rates leave lit­tle room for a loose pol­i­cy dur­ing a pos­si­ble future reces­sion, and ris­ing rates hurt the prin­ci­pal of bond hold­ers now.

Those depend­ing on bonds to ful­fill the con­ser­v­a­tive por­tion of the port­fo­lio may be fac­ing some tough times ahead. Luck­i­ly, there are many mon­ey man­agers employ­ing var­i­ous strate­gies and tech­niques that don’t depend on bonds for cap­i­tal preser­va­tion. Investors have more options than before.

Shift­ing allo­ca­tions from bonds to strate­gies that direct­ly hedge mar­ket risk may feel risky. But it may be a riski­er move to stay with the famil­iar that isn’t work­ing than to try some­thing new that might pro­vide the pro­tec­tion many need.


About the Author

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research at Zephyr Asso­ciates for 11 years.






Important Notes and Disclosures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com353-SGI-090618

By |2018-10-02T10:44:04+00:00September 6th, 2018|Blog|Comments Off on The 40 Don’t Protect