If the Global Financial Crisis ushered in the era of zero yields, the Covid pandemic has made it a semi-permanent affair. We have looked at how lower bond returns have changed asset allocation choices faced by investors. In doing so, we have assumed that all fixed income returns will decrease by two percentage points going forward (from both lower carry and reduced roll down owing to falter yield curves). We have also assumed that the correlation between safe bonds (US Treasuries, MBS), which has traditionally been negative, will go to 0. While this will not completely eliminate the diversification benefits that these asset have for investors’ portfolios, it will materially reduce them. Below are the results of our analysis of efficient portfolios in the pre- and post-Covid world.
Before Covid, efficient portfolios (those sitting on the efficient frontier) consisted mostly of stocks and “safe” bonds (Treasuries, RMBS and IG credit), leaving little room for other asset classes such as commodities. The overall picture does not change when we look at post-Covid efficient portfolios –the only caveat, is that more risk (which translates directly into more equities) is needed to achieve the same returns. Precious metals play a more prominent role in high-return efficient portfolios, but their weight tops out at about 4%.
Looking at the asset allocation of efficient portfolios in more detail yields interesting insights. Pre-Covid, RMBS was preferable to Treasuries in all but very low-risk cases. IG Credit played a role but only for high-risk portfolios. And stocks were always a mix of lower-risk Dividend Aristocrats and higher-risk Nasdaq (the combination of the two being more efficient than the middle-ground S&P 500). In the post-Covid world, RMBS still gets more allocation than Treasuries, but Credit is part of the efficient portfolio at virtually all risk levels – not just at higher risk. Its share, however, never goes as high as it did in pre-Covid portfolios. It is also interesting that for the same level of risk budget, Dividend Aristocrats get a bigger share than the Nasdaq in the post-Covid world compared with before.