The most common approach to how a diversified portfolio should be invested for the long term is referred to as 60/40. To understand this, we need to go back to 1952 when economist Harry Markowitz wrote the Modern Portfolio Theory, which showed that diversifying your portfolio across asset classes increased its risk-adjusted return. Over time this began to manifest itself as a mix of roughly 60 percent of your portfolio in stocks and 40 percent in bonds. The idea is that stocks provide more potential capital appreciation, and bonds provide income (in the form of interest) and capital protection. Historically, the two asset classes have also gone through extensive periods of negative correlation, i.e., when one goes up, the other goes down.
In this note, we discuss the bond side of the portfolio, starting with some basics. As mentioned above, bonds provide income (interest) and capital protection. When you invest in a bond or any debt instrument, you effectively take part in a loan to an entity. In return for making the loan, you expect to receive interest, and when the loan is due, your capital back. US Treasury bonds (Treasuries) are a loan to the US government, and the interest rate will depend on how long the duration of your loan is. Interest rates for short-term lending are generally based on the Federal Funds Rate, which the Federal Reserve governs. Interest rates on longer-term US government bonds are based on the Federal Funds rate and dictated by the supply and demand of the market.
You take two primary risks with an investment in debt: credit risk and interest rate risk. Credit risk is the risk of not getting your original capital back. Given the minimal risk of not getting your capital back from the US government, an investment in Treasuries primarily involves taking interest rate risk. If interest rates rise, the price of Treasuries falls, as will the value of your investment and vice versa.
When a debt instrument has credit risk or the risk of not getting your original capital back, you deserve to be compensated with additional interest. The amount of additional interest depends on how large that credit risk is. Loans to very large, well-capitalized companies carry only a slight premium in interest to Treasuries. However, loans to smaller, less creditworthy companies should carry significantly higher interest rates.
A brief review of history helps put today's interest rate environment into some perspective. In the 1950s, '60s, and early ‘70s interest rates ranged from 2% to 10%. In response to rampant inflation in the late '70s, Paul Volcker, then Chairman of the Federal Reserve, famously raised the Federal Funds rate to a peak of 20% in 1981. Ever since then, the level of interest rates has generally been declining.
In response to Covid in early 2020, the Federal Reserve lowered the Federal funds rate to zero. This was done to stimulate the economy in the throes of a pandemic-induced shutdown. Even as the US and the rest of the world have since staged an economic recovery, interest rates remain at historically low levels. Since almost all debt instruments are priced relative to Treasuries, yields have come down across nearly all parts of the debt markets. For example, high-yield bonds, or loans to the riskiest companies, recently reached an all-time low yield of 3.78%, relative to a historical average of 6-7%. In our view, you are currently not getting compensated for making loans to what are historically some of the poorest credit companies, and the same applies to most other parts of the debt markets.
One of the side effects of this low-yield environment is that investors have reached for yield wherever they can get it. While real estate has always been a place where there is extra yield and should be analyzed on a case-by-case basis, we have also seen a proliferation of lending against esoteric assets such as art and wine. We typically see this kind of behavior in the later stages of a credit cycle, and investors should be cautious. Debt instruments offering significantly higher than typical current yields also means you are taking considerably more risk. We are wary of taking excess credit and interest rate risk at this stage in the cycle. We maintain an allocation to several diversified bank loan funds providing attractive risk-adjusted yield while trading at a discount to their net asset value. Bank loans tend to be senior-most in the capital structure, meaning in the event of a default and/or bankruptcy, the claim is senior to the rest of the stakeholders. Bank loans also tend to be variable rate instead of fixed-rate, meaning they have much less exposure to the movement in interest rates. In addition, the lack of attractive opportunities in debt markets is why we have a relatively large allocation to alternative assets, such as gold and silver, which are historically less correlated to stocks.