08 March, 2021

Caught Between a Rock and a Hard Place

Caught Between a Rock and a Hard Place


In my last post, we talked about Reddit mob shenanigans and, although interesting and perhaps entertaining to follow, for most investors it isn’t material to their long-term objectives. The question I hear most often from investors relates to their balanced portfolio: Is the 60/40 portfolio dead? And should they continue to hold bonds given their historically low yields?

These are good questions, and there is much to consider with respect to our assumptions, potential returns in a crisis, and possible losses should bonds sell-off. However, even if bonds continue to provide uncorrelated returns and capital protection going forward, allocating to them at current yields may still render overall portfolio return objectives extremely difficult to achieve. This problem has caused investors to hunt for extra income across markets ranging from high yield to private credit. As such, investors face the complex challenge of adding more risk to meet return objectives, while managing larger potential losses from those very allocations, creating an even greater “imbalance”. For a refresher on the imbalance in balanced portfolios, read, Your Balanced Portfolio is Not Well Balanced.

In this letter, I will try to answer these new questions and address the following points:

  • The ability of bonds to protect portfolios in a future crisis
  • If there are other asset classes that can take the place of bonds in my portfolio
  • The post bond bull market world: controlling drawdowns.


This problem has caused investors to hunt for extra income across markets ranging from high yield to private credit.


It’s Been Great to be a Bond Investor

For 40 years, investors have enjoyed diversification, risk mitigation, and healthy positive returns from bonds. So much so that I recall from much earlier in my career, a once-prominent fixed income manager presented the case that bonds were the cat’s meow and that you should never invest inequities. Up to that point and until now, he was probably right. Bonds have been in a bull market as bond yields have steadily declined, boosting investor returns because bond yields and bond prices move in opposite directions. They’ve also provided a negative correlation to equities – meaning that when equities have fallen in value, bonds have appreciated – providing an essential ballast to the traditional balanced portfolio.

However, as Shakespeare wrote: “The past is prologue”, meaning the conditions that produced the 40-year bull market in bonds now define the present. The conditions for the future will be different. We don’t have the time to go through all the elements that brought us to today but suffice to say that a large part of the story has been about central banks trying to manage their economies through rate control and, more recently, through aggressive bond purchase programs.

Source: FTSE Russell Universe Index & Mackenzie Investments

However, the total return of government bonds over the decades has fallen dramatically:


*With 10-Year Bond yields at around 90bps, investors can likely expect a total return of 9% over the next decade.      


“…the past is prologue”, meaning the conditions that produced the 40-year bull market in bonds now define the present.


Bonds as Equity Protection

There is little income to be earned by investing in bonds for the foreseeable future, but what about their ability to provide protection during a crisis?  During the last 30 years, there have been four major crises that we can examine. Although the magnitudes differ, yields dipped lower during each crisis. They delivered the “negative correlation” to equities, helping preserve capital through price appreciation as well as still positive yield, providing strong total returns.

Source: Bank of Canada

Asian Crisis: 1/1/1997 – 7/12/1998; Tech Crash: 1/3/2000 – 6/2/2002; Global Financial Crisis: 2/7/2007 – 4/6/ 2009; COVID – 19: 30/4/2018 – 2/4/2020

To understand how difficult it will be to achieve the same returns and, hence, the same level of protection going forward, we need to use the current 10-Year Canadian Government Bond yield of 90 bps as a starting point.

So, for bonds to provide the same protection as they did in the past, yields would have to drop into negative territory by 0.51% to -1.05%. What would have seemed impossible just a decade ago now seems probable, however, quite intolerable. No investor can afford to have 40% of their portfolio with a guaranteed negative return over a 10-year period. Thankfully, the Bank of Canada has said that negative rates are not a tool that they will likely use. In effect, if bonds are needed to provide returns during a crisis and, if there is a floor to how low negative yields might go, investors may need to own even more than they do now to achieve the same historic protection benefits. This may seem quite counter-intuitive to many. An added consideration may be that in a market with yields held stable by the Bank of Canada and limited upside from bonds, the volatility profile of the 60/40 allocation may well be akin to a 100% equity portfolio. However, the important caveat is that the 40% bond portion may well experience negative returns in a correlated bond/equity drawdown, exacerbating the issue.

The limited upside in bonds is already problematic for investors. Despite investor confidence in the current negative correlation regime persisting, and the Fed buying as many bonds as it takes, it is worth considering what could go wrong. Further equity and credit market recoveries may allow the Fed to let rates rise. However, to the passive investor who faces the little prospect of a reasonable return from bonds, the loss may well have been pointless. In the 1970s, during periods of bond declines, yields were high enough that investors made back losses from price declines over a shorter time window and had net positive returns for the decade! However, at today’s very low yields, the recovery of losses will take much longer. However, this is not nearly as disconcerting as all the other things we might envision going wrong:

  • High inflation
  • Central banks loss of control over the yield curve
  • Sovereign credit risk
  • Return of positive correlation between bonds and equities

All of these require strong, active management to navigate in the future. Thankfully we believe that we have the strongest investment teams in the bond space (Franklin Templeton Fixed Income Team, Putnam Investments, and Mackenzie Investments Fixed Income Team), each managing their own slice of the bond portfolio.

Should you replace Bonds with Gold?

Gold has been the most talked-about candidate to replace bonds. Investors have long believed that gold is both a safe haven and a hedge against inflation. However, those of you who have followed me will know, I’m not into anecdotal beliefs, but into facts supported by data. So, let’s try and answer whether buying gold is speculation or an “investment”?

On the one hand, gold doesn’t produce cash flows, so it can’t be valued. Said another way—its price varies based on something other than its ability to provide investors future cash flows. This makes gold a challenging asset for investors (especially for valuation-driven investors like us). Any investment thesis for gold will rely on supply/demand inputs and price discovery based on what the next investor thinks it is worth.

Since our primary goal is to consider whether gold acts as a safe haven, let’s look at the evidence. There have been numerous studies on the topic of gold as an investment, we will ignore those from the World Gold Counsel, they are undoubtedly biased and none of their “research” is subject to vigorous peer review. I’ll reference the “gold standard” (pardon the pun) academic paper “The Golden Dilemma” by Claude B. Erb & Campbell R. Harvey. The following is a chart from the paper that I’ve updated. I found that gold sells off concurrently with equities in 16% of market observations – in which case it’s not a safe haven. In addition, gold has been increasingly correlated to bonds and may be sensitive to unexpected changes in interest rates, such as the “Taper Tantrum” of 2013, when gold fell 13%.

Source: Morningstar Direct

From a portfolio construction perspective, gold is already challenging given that it has a volatility of 17%, which is similar to equities. If we add periods of positive correlation in down markets, the high volatility of gold magnifies overall portfolio volatility significantly. A true diversifier would instead reduce portfolio volatility and drawdown in times of crisis. These characteristics limit gold’s use as a replacement for bonds since it creates a broader range of potential outcomes than bonds. While an investor might expect gold to keep up with inflation in the very long-run, the evidence for holding gold as a safe haven appears to be mixed. In this sense, it may be better viewed as an expensive insurance policy rather than a core holding.


While an investor might expect gold to keep up with inflation in the very long-run, the evidence for holding gold as a safe haven appears to be mixed.


Caught Between a Rock and a Hard Place - What is an Investor to do?

The average balanced portfolio investor is caught between a rock and a hard place when it comes to their bond holdings. Low yields make it difficult to meet return objectives, and bonds in the future will likely not have the same protection properties during a market crisis. As such, investors are left with the stark choice of either taking more risk and/or hoping equities will pick up all the missing returns from bonds. They will be doing so hoping that bonds do not sell off and bond/equity correlations remain stable.

There are no easy solutions, but I can highlight what we have been doing and what investors should consider in this environment. For our part, we have been embracing “alternative yielding” asset classes for quite some time now and have recently - across all of our portfolio families – reduced our Canadian investment-grade fixed income exposure and increased our allocations to strategies that invest in real estate, high yield, currencies, and foreign bonds.


While an investor might expect gold to keep up with inflation in the very long-run, the evidence for holding gold as a safe haven appears to be mixed.

We believe that, in the current environment, these strategies represent a better risk/return trade-off than just traditional bonds and equities. Our analysis of potential drawdown scenarios with allocations in these asset classes suggests a marginal increase in potential drawdown vs. each portfolio's benchmark. However, these strategies demand greater skill given the complexities of the asset classes and the higher dispersion of returns between active managers. We believe that the managers (which includes Hazelview Investments, Franklin Templeton Fixed Income Team, Putnam Investments and Mackenzie Investments Fixed Income Team) managing these asset classes for us have the skill and the scope within their mandates to manage these asset classes effectively.

Embracing Risk Control

In past articles, like The Siren Song and Investing Without an Airbag, you have heard me discuss the merits of risk mitigation strategies. In those articles, I highlighted that the basic problem with using risk-mitigating strategies is one of the opportunity costs generated between crises. The average investor myopically focuses on the drag of these strategies rather than the excess returns that portfolios could have generated by being overweight risky assets. Yet by utilizing risk mitigating strategies, one could be more comfortable holding more riskier assets. This is so given the significant impact that these strategies have on portfolio volatility and drawdowns during market declines.

Accordingly, if you are an investor who is approaching retirement or are currently in retirement and depend upon your investment portfolio for a significant portion of your income, then you should seriously consider our Counsel Retirement Portfolio family or the IPC Private Wealth Portfolios that include the IPC Multi-Strategy Alternatives mandate. The defining purpose of the Counsel Retirement Portfolios and the alternatives family of Private Wealth portfolios is to participate in the long-term returns of global equity markets while minimizing systemic equity drawdowns by investing in defensive equity strategies. These strategies allow us to embrace more equity risk than we would normally. As a result, we have a higher probability of meeting the investor’s retirement objectives without increasing their risk of running out of capital sooner than they might have without these strategies in place.

You’ve heard me say this before; there is no “for sure” when it comes to investing. The future, as we know, is fraught with unknowns that can easily derail well-laid-out financial plans. Achieving those long-term balanced portfolio returns is only going to get harder. Investors need to educate themselves and make investment decisions based upon data, not emotions or opinions while keeping a long-term perspective. Without these qualities, our basic instincts have a very good chance of derailing our long-term objectives.


Stay safe and be well,


Corrado Tiralongo

Chief Investment Officer

Counsel Portfolio Services | IPC Private Wealth