Advisors are acutely aware that fixed-income investment performance has withered in recent years, giving the asset class a new, diminished status. Less well known are signs that bonds have lost their mojo as negatively correlated diversifier against equity risk.

Advisors are hearing about pain aplenty from clients about shrinking yields. But many of these clients aren’t aware that, along with miniscule yields, an increased correlation with stocks is rendering obsolete the traditional 60-40 stocks-to-bonds asset allocation, which had become etched in stone from the 30-plus-year bull market in bonds. Trends now coming into view are like sandpaper erasing deeply etched notions about asset allocation.    

These trends lie beneath paltry bond yields, with the Bloomberg Barclays US Aggregate Bond Index yielding about 1% in late August. Of course, this malaise is no less evident in the 10-year Treasury. With yields slightly over 60 basis points in recent weeks—and real yields below negative 1%—the 10-year is losing its classic reputation as an effective hedge against a falling stock market and provider of steady, low-risk income. And now, things are so dire in the fixed-income world that some investment firms are waiving their fees on money funds to keep clients’ nominal yields above zero.

By contrast, when stocks plummeted in 1987, the 10-year Treasury cushioned the fall with a yield of 10%. And when the financial crisis struck in the fall of 2008, at least it was yielding 3.5%.

One factor suppressing yields in recent years has been the stock market fears of individual investors still scarred from the financial crisis of 2008. Paranoid that stocks could go off a similar cliff, these investors have diminished bond yields by fleeing into them from stocks.

Though they’re not getting good yield, these investors figure, at least they’re getting protection from a stock market rout. Or are they?

Growing Correlation
The reality is that, as both bonds and stocks have benefitted from declines in prevailing interest rates, they’ve acquired more long-term correlation. History shows that the degree of correlation between stock returns and bond yields changes widely over long periods. After decades of positive correlation, the pendulum swung back to negative in the early 90s, giving investors in that bull market an obvious way to diversify. Yet there’s evidence that this negative correlation began to decline at the turn of the century, perhaps out of uncertainty over inflation and real interest rates. So even as the case for using bonds to diversify portfolios was gaining strength, its economic underpinnings were already starting to weaken. In recent years, this correlation has increased.

And now, returns of the behemoth tech stocks driving the market are trading more or less in tandem with bonds. So if a client’s shares of Facebook or Apple (or those of an S&P 500 index fund dominated by them) go south, bonds offer little in the way of a reliable cushion.

As recently as a year ago, who could have foreseen yields being pushed down even lower by the black swan event of the coronavirus’ economic impact, making bonds a less effective hedge against equities? If interest rates rise 1 or 2%—an entirely likely prospect over the next year or two—this would savage bondholders.

So clients need to understand the futility of risking principle for yields below 1%. And adding insult to injury, this scenario involves significant opportunity costs.

Absolutely Nothin?
A paraphrase of Edwin Starr’s classic song about war comes to mind: “Bonds, what are they good for?” Whether you reach the same conclusion as the song—“absolutely nothin”—may depend on whether you expect positive correlation to continue. Yet, as periods of negative and positive correlation have historically run for decades, change in the status quo is unlikely anytime soon.

So clients relying on their 60/40 (their father’s) allocation could be in for a rude awakening unless advisors help them get their heads around these new market realities. Those who see the problem will, of course, be receptive to appropriate changes in asset allocation. But what changes?

The scenario of increasing correlation and soaring large-cap stocks (i.e., tech) suggests ironically hedging stocks with stocks—using the right value shares hedge growth shares. After all, value stocks would likely benefit from an increase in interest rates, and where could current rates go but up?

Hedging Stock Risk With Stocks
This strategy involves substituting bond holdings with shares of solid value stocks that have steady long-term prices and reliable dividends that are well above bond yields.

An example is 3M (MMM), renowned as a dividend aristocrat, as it has a 62-year record of increasing dividends annually. With a current annual dividend of $5.88 and a dividend yield of 3.6%, the company’s share price ($165 on August 25), has seldom  offered a higher yield, as the share price is nearly $100 lower than it was two and a half years ago. In 2007, shares were going for about $100, so 3M’s value has risen despite the Great Recession and the pandemic. Though it’s no juggernaut, 3M is the kind of company that provides investors bond-like stability while paying several times the yield of high-quality corporate bonds.  

Another example is Caterpillar (CAT). Though CAT’s share price has moved around more than 3M’s, it has a similar dividend history, rising from $1.84 in 2011 to the current $4.12, with a dividend yield of $2.9%. And the cyclicality endemic to the construction industry would turn beneficial with a Congressional infrastructure package, which has been talked about for years but could actually happen in the next year or two to finally address deteriorating roads, bridges and airports.

Along with current diversification, adding value stocks to portfolios these days might prove a good way to position for near-term price appreciation, as indicated by recent signals of a potential rotation from growth to value. A few months ago, growth-value spreads had begun to narrow, and since then value indexes have risen. For example, over the 13 weeks ended Aug. 21, the S&P 500 value index rose 9.27%. And over the same period, IWS, the iShares Russell Midcap Value Index ETF, had total returns of 13.61%. Should this trend continue, more institution money managers will likely add such shares, making sanguine value projections something of a fait accompli. (Already, some investment houses are recommending that clients lighten up on growth and add value stocks, particularly mid- and small-cap.)

If a rotation to takes hold next year, inflation may increase (much to the chagrin of holders of existing bonds whose values will be depressed by the availability of new issues paying higher yields). This is viewed as a likely scenario for early 2021 by Jeremy Siegel, renowned economist at UPenn’s Wharton School.

Getting clients to authorize substituting stocks for bonds can be difficult after telling them for years that holding bonds was a good idea—like nutritionists discouraging people from eating foods they no longer consider healthful.

But clients expect advisors to tell them what they truly believe, and the more educable among them can be convinced to loosen their grip on 60-40. If they won’t dump all their bonds, perhaps they could part with some of them to guard against the ironic lack of true diversification that their current asset allocations now pose.

Dave Sheaff Gilreath, CFP, is a founding principal of Sheaff Brock Investment Advisors LLC, an equities management firm in Indianapolis.