Cat bonds offer a source of truly uncorrelated returns amongst refinement of 60/40: King Ridge

King Ridge Capital Advisors has examined how the 60/40 portfolio has come under increased scrutiny in recent years, notably regarding its capacity to hold when financial markets are in distress, while also highlighting how catastrophe bonds’ ability towards offering a source of truly uncorrelated returns is helping redefine portfolio resilience.

The 60/40 portfolio, where 60% is allocated to equities and 40% to government bonds has provided consistent risk-adjusted returns and dependable diversification for decades, King Ridge states in a new report.

However, the 60/40 portfolio has faced criticism in recent years, notably following the 2022 market correction, which exposed a key vulnerability.

“Inflation spiked to multi-decade highs, prompting the Federal Reserve to raise interest rates aggressively. The result? Equities declined, but instead of serving as a hedge, U.S. Treasuries also fell sharply. This instance of dual drawdowns was particularly damaging to balanced portfolios and has recently begun to happen with greater frequency,” King Ridge explains.

In order to mitigate interest rate risk and boost yield, the ILS investment manager highlighted how many asset allocators have diversified into alternative fixed income strategies, which includes high-yield bonds, private credit, real estate debt, and infrastructure finance.

However, as King Ridge warns, while these asset classes offer attractive returns in benign environments, their diversification benefits may be overplayed, with both the global financial crisis (2007-2009) and the COVID-19 market collapse in early 2020 providing critical stress tests.

“Both high-yield corporate bonds and leveraged loans experienced rapid declines in concert with equities. Private credit though less marked-to-market showed similar credit spread behavior. This underscores a key point: alternative fixed income instruments remain fundamentally exposed to the same systemic credit risks as traditional bonds,” King Ridge explained.

Further into the report, King Ridge pinpoints how recent increases in government spending and persistent budget deficits have contributed to a growing national debt burden.

“While interest rates are influenced by many factors, including central bank policy and inflation expectations, sustained fiscal imbalances may place upward pressure on sovereign yields over time,” the report reads.

“Additionally, shifts in investor sentiment especially among foreign holders of U.S. Treasuries could affect demand dynamics and lead to increased rate volatility. These structural considerations underscore the importance of re-examining traditional assumptions about the defensive role of government bonds in portfolio construction,” King Ridge continues.

“In a higher inflation, higher rate world, the assumptions that underpinned the 60/40 portfolio must be reconsidered. Government bonds no longer offer the same downside protection they once did. Traditional credit and even alternative fixed income strategies increasingly exhibit equity-like behavior during downturns.”

Concurrently, the ILS investment manager suggests that instead of abandoning fixed income entirely, the focus should shift towards the risk type diversification, and not just sector or geography.

Of course, this is where catastrophe bonds come into fruition.

“CAT bonds provide a return stream derived from insurance risk, a factor that does not rely on economic growth or central bank policy,” King Ridge added.

Highlighting Swiss Re’s Global Cat Bond Index, King Ridge states that the Index serves as a useful benchmark.

“With only two negative return years since its inception in 2002, the index has demonstrated remarkable stability and delivered solid returns even in years marked by financial market stress,” the ILS investment manager noted.

Furthermore, King Ridge goes on to suggest that modern portfolios need to account for correlation breakdowns in traditional hedges, the diminishing marginal value of credit-heavy alternatives, as well as structural fiscal risks that may pressure sovereign debt returns.

“In today’s market, the real catastrophe may not be hurricanes or earthquakes—it may be the synchronized collapse of equity and fixed income portfolios built on outdated diversification assumptions. CAT bonds offer something most traditional and alternative fixed income instruments can’t: independence from the broader economic cycle,” King Ridge concludes.