Why bonds are no longer the last word in risk-management when it comes to your portfolio.

The 40-year bull run in bonds has had a profound impact on how people view the role fixed-income securities play as a risk-management tool when it comes to portfolio construction. As far back as I can remember, bonds have been touted as the best way to diversify against equities. Even regulators, zeroing in on the investment policy statements that disclose a client's ability and willingness take on risk, directly measure that risk appetite against the proportion of bonds a client holds.

Using bonds as a risk-management proxy has worked exceptionally well because interest rates, after peaking in 1981, have trended lower for the greater part of the past four decades. This decline came as huge technological innovations that streamlined operations and manufacturing along with the scaling of connectivity via the internet resulting in the digitization of the global economy, putting disinflationary pressure on the global economy. Central banks have also been very accommodative, reducing their inflation expectations and adopting low interest rate policies.

As a result, there was plenty of room for interest rates to move lower and therefore for bond prices to move higher, in particular during market corrections. Specifically, long-dated government bonds have been one of the most effective tools to manage risk, as seen as recently as the March 2020 COVID meltdown.

The problem now is that government bond yields are trading not far off their lows despite a rebound in equity markets, thanks to a U.S. Federal Reserve intent on keeping them low through open-market operations.Take the U.S. 10-year, which is currently yielding 1.15 per cent compared with 1.92 per cent at the end of 2019. This may not sound like much but an 80-basis-point move higher will result in a 5.9-per-cent corresponding drop in the Treasury

price, according to analysis by the National Bank Investments CIO Office.

This has motivated investors to seek yield in other areas of the bond market, chasing investment-grade corporate bonds and even pushing junk bond yields to new record lows. The problem is that this leaves little upside potential and a lot of downside risk as one shouldn't forget the carnage experienced in both of these markets last year when they went no bid. Investors are also equally enticed by current equity yields, as nearly three-quarters of S&P 500 stocks now offer a yield higher than the 10-year Treasury.

Not surprisingly, a plethora of alternative fund managers are trying to capture this interest by selling the merits of their strategies as a fixed-income replacement when in reality, from what we've witnessed, many simply replicate equity like returns and risk — which did little to nothing to protect portfolios during last year's meltdown. Then there are the private real estate and equity funds promising low correlations simply because they have no transparent market to show the real fluctuations in valuations. Of course there is a low correlation when something that isn't marked-tomarket on a regular basis is compared to something that is.

So where does this leave the traditional 60/40 investor looking for a better solution than onboarding more risk? Fortunately, there are a couple of options.

Tactical Asset Allocation has been one tool proven to be very effective. This means being flexible and dynamic with one's fixed-income weightings and duration exposure. For example, we've come across some great portfolio managers out there who have been able to quickly adjust portfolios based on an emerging change in market conditions. This includes adjusting weightings to government, investment grade and corporates according to valuations along with managing durations. Additionally, global allocations including currency management will likely be a very important factor looking ahead, especially considering how some governments, including our own, are putting their economic standing at serious risk.

Structured notes are another area that we have found particularly useful as an alternative to bonds while still providing strong target returns without excessive risk. Technically they are counted as equity on an Investment Policy Statement for compliance purposes, however, they provide strong downside protection as compared to simply going long stocks. For example, we've been able to structure some notes that will pay a 4.5- to 5-per-cent yield as long as the broader market like the S&P TSX doesn't fall more than 40 to 50 per cent. Given they have such a large downside barrier, we think it's a much better option when the rest of your portfolio already has a large equity weighting.

Finally, in a rising interest rate environment, inflation-sensitive equities should offer higher returns that more than offset the impact on bonds. Therefore, one can tilt their equity exposure to these segments of the market such as energy, materials, consumer staples, health care and utilities while concurrently reducing one's risk on the fixed-income allocation to perhaps shortand medium-term governments.

In conclusion, we think the 60/40 portfolio will be around a lot longer than many believe, but the way it looks will be different than the balanced portfolios of the past. A plain vanilla stock/ bond portfolio, in other words, simply isn't going to cut it in the current market environment. Ultimately, the goal is achieve the best risk-adjusted returns and that now requires expanding one's risk management toolkit beyond just fixed-income.