What Can Defend Against Fixed Income’s ‘Conundrum’?

Enrico Dallavecchia

David X. Martin

For the past hundred years, the classic 60/40 portfolio—allocating 60% to equities and 40% to fixed income—has been the default portfolio for investors. It worked because it did not require investors to predict the future; it delivered a reasonable balance between growth and stability, no matter the market environment.

For instance, from 2016 through 2025, a hypothetical 60/40 portfolio with 60% invested in the S&P 500 Total Return Index and 40% invested in iShares 7- to 10-Year Treasury Bond Exchange-Traded Funds, returned 9.52% annualized and 6.11% after inflation, with realized volatility of 9.82%, well below an all-equity portfolio, and finished positive in eight of 10 calendar years.

But those numbers tell only part of the story. Investors stayed with 60/40 portfolios because it was easier to stay invested through difficult markets. Much of that came from the bond allocation, which generated income while offsetting part of the losses when equities sold off. But today, that relationship is much less reliable.

What the 40% Was Supposed to Do—and Didn’t

No one owned the 40% because they expected bonds to outperform equities. They owned it because it did two jobs equities could not do: It generated income, regardless of whether equity markets were rising or falling, and it provided ballast. When equities fell, high-quality bonds tended to rise, or at least hold, cushioning the drawdown and giving the portfolio something from which to rebalance.

When growth slows, investors typically expect interest rates to fall. Bond prices rise as yields decline, offsetting part of the losses in equities. It depended on one condition: that stocks and bonds move in opposite directions during periods of market stress.

For most of the post-2000 period, they did just that. In our data, the monthly correlation between the S&P 500 and an intermediate Treasury position was −0.40 from 2016 through 2020. That condition ended in 2021, when inflation changed the relationship: Rising interest rates began putting pressure on both stocks and bonds at the same time. Instead of offsetting equity losses, bonds started contributing to them. From 2021 through 2025, the stock-bond correlation turned positive (+0.55), reaching +0.61 in 2022. BlackRock and J.P. Morgan echo this point—bonds remain reliable diversifiers in recessions, but fail as hedges in inflation-driven shocks.

In 2022, for example, the previously mentioned hypothetical 60/40 portfolio would have fallen 16.64%, with the bond sleeve down more than 15%, eliminating much of the protection investors had historically expected from the bond allocation. The Bloomberg U.S. Aggregate fell about 13% in 2022, its equity correlation moving from roughly zero from 2016 through 2020 to +0.62 from 2021 through 2025.

For an allocation whose entire purpose was to behave differently from equities under stress, this was a failure of role, not of return.

Because equities are more than twice as volatile as intermediate bonds, the 60% dominates portfolio risk, regardless of correlation regime. Returning to the hypothetical 60/40 portfolio, the equity sleeve accounted for 89% of total risk from 2016 through 2025. In risk terms, the portfolio behaves more like an all-equity portfolio than its capital weights suggest.

The discussion has shifted beyond simply holding stocks and bonds. The real challenge is building a portfolio with return drivers that remain genuinely independent of one another.

Reconsidering Defensive Allocation

If part of the traditional bond allocation no longer provides the diversification investors expect, the next question is: What should replace it?

The natural instinct is to move more capital into bonds, but recent experience suggests that may not solve the problem. When inflation became the dominant risk, stocks and bonds started moving together, instead of offsetting one another. In that environment, increasing exposure to interest-rate-sensitive assets may reinforce the same risk, rather than diversify it.

Some institutional investors have responded by reallocating part of the fixed-income allocation into strategies whose returns are less dependent on interest rates and equity markets.

Importantly, this capital is being reallocated from the defensive allocation, not from equities. Some strategies remain closely tied to the same market forces driving stock-and-bond portfolios. Others rely on genuinely independent return drivers, so that diversification does not depend on a single macroeconomic regime.

Diversification, Resilience, Ballast

Not all alternatives solve the same problem. Some strategies are designed primarily as insurance, providing meaningful protection during sharp market declines but often at the cost of long-term returns. Others may generate attractive returns, but remain closely tied to equity or credit markets, limiting their diversification benefits during periods of market stress.

This distinction between insurance and ballast has become more prominent as investors reassess how portfolios behave during periods of stress. Insurance is typically intended to respond during acute crises. Ballast is different. Rather than paying a recurring premium for event-specific protection, it seeks to provide a more consistent source of diversification while preserving return potential.

For that reason, investors considering alternatives as part of the defensive allocation should look for strategies whose return drivers remain genuinely independent of both equity markets and interest-rate movements. The objective is not to replace equities or maximize returns; it is to restore the defensive role the 40% was originally intended to play.

Both former chief risk officers, David X. Martin and Enrico Dallavecchia are co-founders of Arctium Capital Management.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.