Bonds Lose Diversifier Role; Active Strategies Gain Interest

For decades through 2020, low interest rates and steady equity gains meant many investors treated bonds as portfolio ballast. Rates began rising in 2021, and through 2022 stock and bond returns moved closer together. In 2022, bonds failed to offset equity losses and correlations between stocks and bonds rose to levels not seen since the late 1990s. Correlations have remained elevated since then.

Market participants report that the shift has prompted investors and advisers to reconsider how they use fixed income. Flows back into bond markets this year have been driven in part by automatic allocations such as 401(k) plans and model portfolios rather than by fresh, broad-based investor demand.

Phil Toews, in his book The Behavioral Portfolio, wrote that bonds can add stability but that their effectiveness depends on valuations, interest rates and inflation. He also pointed out that corporate stocks and corporate bonds ultimately reflect the same companies, which can limit bonds’ ability to offset equity losses in some market environments.

Asset managers tracking dispersion and volatility say higher yields, wider differences among sectors and ongoing macro uncertainty have created more opportunities for active bond management. These managers describe the tools they use as adjusting exposure to duration, shifting between nominal Treasuries and inflation-linked securities, and altering credit quality exposure. Passive, broad bond indexes continue to offer low-cost exposure, but they do not change positioning when rate, inflation and credit risks move at the same time.

Several firms are marketing tactical fixed-income strategies that combine rules-based signals with discretionary decisions to rotate among Treasury securities, corporate bonds, Treasury Inflation-Protected Securities and cash. Proponents of these strategies frame their objective as limiting principal loss while pursuing income and modest capital return, aiming to participate in favorable fixed-income periods and seek shelter when risks rise. Eben Burr, president of Toews Asset Management, observed, “The goal is not to make bonds exciting. Please, no one needs that.” He added that the aim is to make fixed-income allocations more useful in the current market environment.

Interest in alternatives and private credit has increased as some investors search for yield and sources of return beyond traditional bonds. Industry participants note that these products can offer higher returns but often include complexities, limited liquidity and structural terms that require due diligence. Market observers caution that such products are not direct substitutes for a managed core bond allocation.

Advisers and strategists recommend that investors reviewing active or tactical fixed-income options assess manager track records, risk controls, liquidity provisions and fee structures. The recent pattern of higher yields, wider sector dispersion and persistent volatility has led to closer scrutiny of fixed-income allocations by investors and advisers.