Thinking Outside the Bond Box: The New Look for 60/40 Balanced Portfolios

In this episode, I dive into the challenges facing traditional 60/40 balanced portfolios and explore innovative alternatives to rethink how we invest. From the shortcomings of fixed income in today’s market to strategies like private credit, long/short equity, and structured notes, I break down practical solutions to diversify risk and enhance returns. If you're ready to think outside the bond box and reshape your investment approach, this episode is for you! Let’s get started.

Disclosure: "At the time of this article I currently hold shares in some of the companies mentioned as part of investment portfolios in funds I manage for Belpointe. Additionally, I may discuss other securities that are under consideration for future investment; however, discussing these securities is not a recommendation to buy, sell, or hold. My mention of these securities reflects my personal opinion and analysis at this moment and may change without notice. Please remember that all investments involve risks, including the possible loss of principal."

Transcript

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As a strategist and someone who loves to talk about capital markets, stocks or equity are the focus of most financial blogs, podcasts, research, newspaper articles. And why shouldn't they be? Over the long run, they generate the most returns. We get to talk about fascinating topics like artificial intelligence, biotechnology, more than 100 industries, along with a few thousand companies making everything from paper cups to technology that someday might help us reach the other side of the solar system. Every now and then, we stumble into a stock that goes ten X enforcing our belief that we have somehow mastered the markets well. I'm guilty as well. But as rewarding as stocks are for many. Placing all of your capital in growth assets. Is financial malpractise. We need some choices. And for the last couple of centuries, fixed income and its role in the 6040 portfolio has been your go to tool for most investment houses and advisors. Unfortunately, as any bond investor will tell you, this has been a challenge for years and has clearly not provided the income and more importantly, the protection that investors should demand from risk off assets. Take a look at the AGG ETF, which is a good proxy for the Bloomberg Aggregate Bond Index and a benchmark for most fixed income funds and portfolio managers. In the last three years, you lost about 7%. Even in the last five, you still lost money. And if you were brave enough to hold on for the last decade, you made a whopping 13%. I don't mean annually. I mean, that was your total return. Now, there's no evidence he actually said this, but Albert Einstein is believed to have coined the phrase insanity may be defined as doing the same thing over and over and expecting different results. Well, we need some answers and we need them right now. Continuing to invest in a strategy that hasn't worked for ten years and may not work for another ten is insane. Welcome to The Money Runner. I'm David Nelson. It is time to think outside the box and start coming up with alternatives. That, in addition to providing negative correlation with other risk assets like stocks, actually make some money. Historically, when the fed cuts rates, bond investors stand to make a lot of money all across the curve. But so far this cycle, that has not happened. The Fed funds rate this cycle has been cut by 100 basis points, and today ten year treasury yields are up 100 basis points. So depending on the vehicle, it turns into about an 8% loss. In hindsight, the reasons why traditional fixed income strategies have failed are obvious. Ben Bernanke ushered in the era of quantitative easing, sending the world down a path of financially engineering economies in an effort to eliminate the business cycle. Now, I think few would argue with the necessity during the great financial crisis. Financial markets and institutions were on the verge of collapse, and the depression that would have followed was likely worth the cost. Like most things in life, too much of even a good thing has unintended consequences. The hangover or ultimate cost may be more than you bargained for. The Fed continued to use QE tools for years and didn't stop until March of 2022. This, of course, ushered in the era of zero interest rate policy, a period that wiped out savings for conservative investors, leaving them with few alternatives to generate income. The good news is that a Fed balance sheet that ballooned almost 9 trillion has shed close to 2 trillion of that debt. As Jay Powell and company have continued to bleed off the excess normalization has a cost and we may be feeling some of that on the long end of the curve today. If the Fed was the only reason fixed income hasn't worked like it has in past cycles, I'd say we were on a path of repairing the damage. But one look at the income statement and the balance sheet of the United States of America ends that fairy tale once and for all. High debt and ballooning deficits don't matter until it does. The good news is our GDP continues to expand. And with the introduction of new and exciting technologies like artificial intelligence, the productivity benefits might someday give us a GDP print of 5%. But as I pointed out in last week's podcast, 2025 Market Mission Brief, Total U.S. debt is starting to rise exponentially, and that has not gone unnoticed by our creditors. Apple's cheap fixed income strategist, Lawrence Gillam, has done some excellent work on this subject. He points out in a recent note that term premium is making its way back into fixed income. Term premium wonky word. What is that? It is the extra return investor's expect to receive for holding longer term bonds instead of short term securities. It's been depressed for years, but as you can see in this chart, it is climbing and may continue to climb for some time, even if the Fed cuts more than expected. Long rates may continue to rise. When you are running debt and deficits, this large supply becomes a factor. Like any commodity, when there is excess supply prices go down and in this case, forces yields higher. Okay, we've laid out the problem. So let's look at some of the solutions. We have two jobs in front of us. First, we need an asset class that either has negative correlation or at least reduces downside risk when conditions deteriorate. There are several, and ultimately the solution will likely be a basket approach using multiple funds or ETFs for each asset class. Let's get the easy solutions out of the way first. The Barbell. One of the easiest ways to reduce your risk would be a 6040 split of stocks and bonds. Only this time use the short end of the curve with Treasuries two years or less. No, you won't get the negative correlation that you're supposed to get from long dated treasuries when economic conditions soften. But you haven't been getting that anyway. When you look at a chart of ten year yields alongside the Bloomberg Economic Surprise Index bonds aren't acting like they're supposed to. In the last few months, the index has trended lower and yields should have trended lower as well. But here they are on I-95 north. Let's build out the barbell. Let's say you have a two year time horizon. Today, you could lock in a two year treasury at 4.2%. All right. We're starting with 100 K. If you were running a 6040 portfolio and put 40,000 into that two year note, you would generate just over $3400 over the next two years. On the equity side, let's assume two binary outcomes. The first is the market's down 20% over the next two years and the second you’re up 20%. Scenario one Your equity lost $12,000, but when you add in the 3400 from your bonds, your net loss is 8600 or -8.6% return. Scenario two You made$12,000 in stocks and when you adding your fixed income return, you bump up your gains to over 15,000. Or better than 15% return. You captured 77% of the return of an all in equity portfolio and 43% of the downside when the market's headed south. Every period will be different, but not a bad risk reward trade off and very easy to put in motion. Private credit. Private credit has exploded in the last ten years. Deutsche Bank, in a recent note, points out that financing is generally floating rate and loan sizes of between ten and 250 million, with terms as much as 400 basis points above public debt. That's a significant premium. However, this is not for everyone there is an illiquidity premium built in. Funds like this often have specific times when you can access your principal floating rate securities. They can work well, especially in a rising rate environment. They have advantages, but also have their share of risk. On the plus side, yields follow overnight lending rates, and if rates are rising, so is income. On the downside, credit quality is generally lower. And as you can see in this chart during COVID, they cratered, offering no protection at all. Long, short equity, hedge funds, even ETFs. They often have low correlation and sometimes even inverse correlation. I've used several in the past, and I can tell you it is better to use a basket approach over the long run. This has been an excellent alternative. But I can tell you running long short is challenging and few managers ever master the art. You need to do your homework. You look at performance through a full market cycle, not just a bull or bear market. Remember, past performance is not indicative of future returns. In the end, some combination of all of the above is maybe the best approach to a revamped 6040 mix. Will long term fixed income ever resume its historic role? Look, I think in severe economic and geopolitical events, long term treasuries will provide the inverse correlation you seek. But those events are often fleeting and repair themselves quickly. There are lots of other choices we haven't even gone into today, including structured notes, buffered ETFs and derivatives. Hope to get to all of these in the weeks ahead. All right. That's it for this week. If you want to learn more about yours truly or the money runner, go to my substack site. dcnelson123@substack.com I'm David Nelson and this is the Money Runner.