Rethinking Fixed Income—Searching for Alpha for September 2012

For decades, investors have been offsetting their equity risk with allocations to fixed income. And as each of these asset classes sit on opposite sides of a firm’s balance sheet, the resulting noncorrelation gives this strategy considerable heft.  But as rates have plummeted toward nil—and in many cases sport a negative real yields return—it’s time to rethink the role of bonds in a portfolio. 

Let’s face it: with a yield of less than 1.5% on a ten-year Treasury, bonds do not have much further to fall. The party will likely last a little while longer, as retail investors continue to buy bond funds with wild abandon, but after all their money has been spent we could be facing a trade with no more money left to fuel the 30-year bull market in fixed income. 

If yields rise for the right reasons, which include economic growth and modest inflation brought about by more demand, equities will be a great hedge against falling bond prices. But if yields go up simply because there aren’t any bond buyers left, companies will be facing more expensive financing and stocks will suffer as a result. Either of these scenarios will result in losses for bondholders.