Fixed income, the stalwart of diversification in portfolios, may no longer fill this role. In a video, “How to Find Diversification,” Morgan Stanley equity analyst Michael Cyprys and strategist Andrew Sheets note a very different market environment for fixed income as a diversifier and openly search for new diversification tools in a world of negative interest rates.

MS Diversification photo

 

Fixed income has had an amazing run as an investment and it is about to end

The traditional 60%/40% portfolio theory included the largest percentage to stocks but a respectable 40% to what was considered the portfolio “diversifier,” fixed income.

Investors should recognize just how good fixed income has been at diversifying a portfolio, Sheets said. The returns have been better than equities depending on issue selection. This better overall performance comes with lower volatility, Sheets noted.

“Fixed income has had a negative correlation with equities,” Sheets said, noting that it has been a big “shock absorber” during crisis. This is about to change.

He says forward looking models point to a future Sharpe ratio worse than that which investors are accustomed.

With yields near negative, fixed income won’t have the same latitude as a diversifier

NIRP negative rates

Calling out bonds as a poor diversifier is nothing new to an industry that lives and breathes diversification. But to have an equity-focused legend like Morgan Stanley actively call for a replacement diversifier is interesting.

Sheets says that many of the circumstantial exposure that helped fixed income perform so well during the previous time period has evaporated and “fixed income may not be a diversifier going forward.”

With bond yields at their lowest levels in recorded history, interest rates would need to fall well below zero to provide diversification in an equity sell off, he said. Thus, the beneficial negative correlation that fixed income had exhibited with equities might falter.

“We can’t bank on the same negative correlation,” Sheets said. Going forward it might be more difficult for fixed income to reproduce the returns of old, he said. The bond yield rally that investors have enjoyed throughout most of the modern era of finance is over with rates near zero.

Sheets and Cyprys pointed to the need for investors to adapt and evolve, pointing to the need for new diversification strategies to develop. “We need to find new tools to diversify,” was the mantra the trio expressed. To do this the pair look to less liquid credit, strategies that involve currencies and volatility. “Using volatility and selling volatility screens surprisingly well,” Sheets said.