Investing Without a Parachute

In a post-coronavirus investment world, Jeff argues that investors should be rethinking the role of fixed income in portfolio construction and ask themselves if they are at risk of investing without a parachute?

In the wake of the coronavirus crisis, the U.S. bond market finds itself flirting with negative interest rates and bumping up against the “zero lower bound”—calling into question the ability of bonds to provide ballast in future equity sell-offs.

Rethinking fixed income at the “zero lower bound”

Historically, investors have allocated to fixed income to meet any of three key objectives: capital appreciation, income generation, and preservation of principal. Fixed income’s typical ability to provide ballast against equity sell-offs rests in the normal response of lower interest rates to falling stocks—resulting in a general negative correlation between bonds and stocks. When stock prices fall, bonds prices tend to rise. However, in recent years, super low, zero and even negative interest rates have driven up the value of fixed income securities limiting further capital appreciation and calling into question the asset class’s ability to diversify against future equity drawdowns.

At the same time, the coronavirus crisis is pushing the Fed to lower interest rates to zero for the second time in just over a decade. Now, policy makers are bumping up against the “zero lower bound” on interest rates—or theoretical lowest level that interest rates can fall to before they become unenticing to investors and ineffective as a way to stimulate economic growth. While it is true that negative rates have been seen in other countries around the world before, the scope of negative rates is limited. Why? Interest rates cannot fall (much) below zero because if they do, investors have the option of holding cash which pays no interest, but that is better than a negative-yielding asset.

In this historically unprecedented period, investors should be rethinking the role of fixed income in portfolio construction and ask themselves: Am I investing without a parachute? The answer requires a reexamination of the Global Financial Crisis and the last bout of zero interest rate policy.