Insight post

Sep. 6, 2018

The 40 Don't Protect

Will Bonds Protect in the Next Bear Market?

Portfolio protection is now top of mind right for many investors.

With U.S. equities pushing all-time highs, a flattening of the yield curve, and the unknown impact of potential trade wars, many investors are justifiably concerned.

Advisors usually recommended significant bond allocations to hedge their clients’ portfolios, and historically, it has worked.  For example, during the most recent bear market from November 2007 until March of 2009, the Barclay’s Bond Index rose 6% while the S&P 500 Index fell 50%. Thus, a balanced portfolio of 60% stock / 40% bonds fell around 27%, and a 40/60 portfolio fell only 15%.

But the landscape has changed.

The environment of low but rising rates presents a challenge to those investors seeking protection and capital preservation from bonds.

How Low Can You Go?

Over the last 30 years there have been three times in which the Fed entered an extended period of loose, accommodative monetary policy in order to help ease the economy through a recession.  In all three cases bonds performed admirably well. As rates fell, bond values increased, helping offset losses associated with the equity markets. If the standard, balanced portfolio contained 60% in equities and 40% in fixed income, that 40% allocation to bonds was vindicated.

Fed Hikes and Recessions - The 40 Don't Protect - Swan Insights

Source: U.S. Treasury, Zephyr StyleADVISOR

The previous three recessions started with the Federal Fund rate over 5%.  In each case the Fed was able to cut over 500 basis points from short-term lending in order to help boost the economy during a recession.  The Barclays Aggregate U.S. Bond Index performed quite well during these periods, providing positive returns that offset losses in the equity markets.

Were a recession to start today with short-term rates in the 1.75%-2.00% range, the Federal Reserve would have much less scope to implement a loose monetary policy. They might push rates back to 0.00%, but the gains to bonds will likely be less due to the lower starting point. With less of a value increase, the protection role of bonds is much weaker than before.

Keeping an Eye on the Yield Curve

Is a recession imminent? No one knows for sure. Debating the relative strength or weakness of the economy keeps thousands of people occupied and gainfully employed. But one yellow flag is the recent flattening of the yield curve.

Yield Curve as of June, 2018 - The 40 Don't Protect - Swan Insights

Source: U.S Treasury

Over the last year the short end of the curve has moved up significantly, while the long-end has barely budged.  While the yield curve hasn’t yet inverted, long time market watchers know this is a bad omen.  For those needing a refresher on the importance of flat or inverted yield curves, the New York Times recently ran this piece in June: “What’s the Yield Curve? ‘A Powerful Signal of Recessions’ Has Wall Street’s Attention.”

Rising Rates Hurt Capital Preservation

Maybe you’re of the opinion that the economic expansion has room to grow, and you don’t see a recession on the horizon. Assuming the Fed continues on its path of tightening under healthy market conditions, the impact on bond prices will be negative. As prices and yields are inversely related, bond holders could feel a lot of pain as rates increased by 3% to their historic average levels. While this may mean good things for those who want income, it’s a problem for those who are seeking capital preservation.

The table below shows the average durations of different types of fixed income managers and how susceptible they are to losses in the face of rising interest rates.

Bond Categories - The 40 Don't Protect - Swan Insights

Source: Morningstar Direct, Swan Global Investments

We’ve already seen this bear out a bit in 2018, as many bonds have lost money in the first half of the year.

Interest Rates Increase - The 40 Don't Protect - Swan Insights

Source: Morningstar Direct

If rates continue to rise in a healthy economy, bond holders can expect more losses.

Rethinking Capital Preservation and the Traditional Portfolio

In a related note, the start of 2018 bears a striking resemblance to the start of 2007. VIX was at similarly low levels to start the year. However, 2018 has seen numerous concerns rattle the markets—the end of the easy money period, rising inflation, a potential trade war, etc. Will we see the markets shift from a low volatility regime to a mid-volatility regime, which the DRS prefers? Time will tell.

This recent series of blog posts provided an executive summary version of the three primary drivers of DRS performance during downturns.  For a more in-depth exploration, please refer to the white paper “Managing Expectations: Drawdown Scenarios and Swan DRS Performance Analysis.”  In addition to these three primary factors, the paper discusses various special situations like V-shaped recoveries, extended declines from heightened volatility, whipsaws, and the differences in volatility regimes.

About the Author:

Marc OdoCFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly, Marc was the Director of Research for 11 years at Zephyr Associates.

Research from this Author
Important Notes and Disclosures:

Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes non-qualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS®).


All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970-382-8901 or 353-SGI-090618