Fire and Brimstone! Human Sacrifice! Dogs and Cats Living Together! It’s the Long-duration Bond Apocalypse! And it’s not even the price decline which is the scariest part (that’d be the correlation). How might Risk Parity investors respond?
Normally, I’m not one to report too much on market news: there are oodles of others out there doing that, and anyway, I try not to act on the news that I see (I just follow the numbers on my asset allocation worksheet). But, this is one of those cases that is so dramatic that it deserves some scrutiny and commentary:
Simply put, we’re in the midst at a Global Financial Crisis-level decline for long duration bonds:
EDV, my preferred ETF for fixed income investing, is now trading at 65.02, a 52% decline since I started tracking it as part of my test portfolios in July 2021. I even hold some TMF, Direxion’s 3X Leveraged Treasuries ETF, which is down 53% over the past six months. And as bad as it has been, it may not be over.
Bond Declines in RP Portfolios
Its no surprise then that the decline in long-duration bonds has hit many of my Risk Parity test portfolios quite hard. For the past few months, traditional portfolios like the 100% Equities, the 80/20 and even the 60/40 have been at the top of the table in the overall rankings (1st, 3rd, and 4th, to be exact).
Meanwhile, bond-heavy and long-term bond tilted RP portfolios have been stinking up the joint, none more so than the Qian portfolio which essentially functions as a 33% equities, 25% alternatives, and 142% fixed income combination. That portfolio has now lost 41% since inception, and almost 10% last month alone. Its trainers are probably in the corner right now, getting ready to throw the damn towel.
RP portfolios have been vulnerable to these price declines for a pretty straight-forward reason - they typically allocate more towards the longer end of the bond spectrum since these bonds have more volatility, which helps to balance out the higher typical volatility of equities. In the RPC Income portfolio, for example, a 15% allocation to EDV helps balance out the 5% allocation to the 3X Leveraged UPRO. With that kind of volatility on the equity side, a more stable fixed income fund like intermediate-term Treasuries (VGIT) or even Long-term Treasuries (VGLT) wouldn’t quite have enough juice. Note: I go over my thoughts on EDV more here, and on VGLT more here.
The higher volatility of EDV is not a bug, but a feature, and as that asset class has declined, it has taken lots of the RP portfolios down with it.
The Real Problem
The price decline for long-term bonds is only part of the story, though. Back to the volatility: the inherent bet that Risk Parity portfolios make is that if there are huge declines in bonds, they won’t occur at the same time you have huge declines in equities. Bonds and stocks have, over the past few decades, usually had a negatively correlated relationship: when one goes up, the other goes down and vice versa.
Here is their correlation between 2008 and the end of 2022:
At least, that's the way it is supposed to work.
And that is NOT AT ALL how it is working now.
The difference in returns from 2008 to 2022 compared to 2023 is huge, +4 vs. -14%. But the thing that should catch your eye is the correlation: -.22 compared to .85 now. Essentially, there has been no risk balancing benefit for long-term Treasuries over the past year, along with dreadful raw performance. It has been the worst of both worlds for Risk Parity investors.
The Options for a RP Investor
Faced with this new information, what can the Risk Parity investor do?
Essentially, it comes down to a question I have covered before:
Option 1: In this case, the procyclical approach would be to move with the recent trend and lower one’s allocation to long-term bonds. They are more volatile now, which is a proxy for risk, and given Risk Parity’s mandate to balance risks, one logical response would be to cut back on allocations to the riskier asset to bring risk profiles back in line. That might be just a short-term response, and RP investors could get back into bonds once they settle down. Or, more drastically, this could involve cutting back on bonds for now, and permanently lowering the allocations to them. If long-term bonds are no longer negatively correlated with bonds, then there really isn’t much reason to have very many of them in a portfolio. Such a move would make sense if you believe the positive correlation over the past ten months is the pattern for the future, as well.
Option 2: The countercyclical approach would be to actually pour money into them in accordance with the adage of buying low and selling high. Maybe it’s like catching a falling knife, but if this is at or near the bottom for EDV, then it makes sense to get as many as you can while they are on sale. In terms of correlation, this would also be a bet that the negative correlation of 2008 to 2022 will return at some point, and long-term bonds would regain their diversification benefit.
Money Where My Mouth Is
If you’ve been reading me for awhile, you’ll know that I favor approach #2. I have set up my test portfolios to rebalance into falling assets, and my latest portfolio review featured three such rebalancing out of assets like gold, commodities, and managed futures into EDV and TMF. In real life, I have been on a furious pace of buying up long-term Treasuries with every spare investment dollar I have.
Is that the right course of action? I can’t say for sure, and I wouldn’t naysay anyone who went with the first option. If positive correlation between stocks and bonds is the pattern of the future, then that’s the right call; if the negative correlation returns, then I think option #2 will be the correct one.
If only I had a crystal ball, right?