The 60/40 Fixed Income Conundrum: Rebuilding the Defensive Allocation

Since 1926, the classic 60/40 portfolio, allocating 60% to equities and 40% to fixed income, has been the default portfolio for generations of investors. It worked because it didn’t require investors to guess what came next. Across very different market environments, it delivered a reasonable balance between growth and stability.

Over 2016–2025, a 60/40 portfolio returned 9.52% annualized, 6.11% after inflation, with realized volatility of 9.82%, well below an all-equity portfolio, and finished positive in eight of ten calendar years.[i] Those numbers tell only part of the story. Investors stayed with the 60/40 because it was easier to stay invested through difficult markets. Much of that came from the bond allocation. It generated income, but just as importantly, it often offset part of the losses when equities sold off. That relationship has become 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 couldn’t. 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 to rebalance from. Vanguard frames these same two functions — income and ballast — as the core of the allocation.[ii]

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 when it matters. For most of the post-2000 period they did: in our data, the monthly correlation between the S&P 500 and an intermediate Treasury position ran −0.40 over 2016–2020.

That condition broke in 2021. 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. Over 2021–2025, the stock-bond correlation turned positive (+0.55), reaching +0.61 in 2022. BlackRock and J.P. Morgan have made the same point — bonds remain reliable diversifiers in recessions but fail as hedges in inflation-driven shocks. ⁱⁱ

2022 was the demonstration. A 60/40 portfolio fell 16.64%, with the bond sleeve (IEF, the iShares 7–10 year Treasury Bond ETF) down more than 15% — eliminating much of the protection investors had historically expected from the bond allocation.[i]  Nor was this an artifact of Treasury duration: a broad investment-grade sleeve behaved no better. The Bloomberg U.S. Aggregate fell about 13% in 2022, its equity correlation moving from roughly zero over 2016–2020 to +0.62 over 2021–2025.[i] 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. Over 2016–2025 the equity sleeve accounted for 89% of the 60/40’s total risk while holding 60% of the capital; the bond sleeve, at 40% of capital, contributed 11%.[i] The portfolio is far less diversified than its capital weights suggest — and when the 40% also stops hedging, the investor is left holding what is, in risk terms, very nearly an all-equity portfolio.

This reframes the question allocators now face, not whether a portfolio holds both stocks and bonds (most do), but whether its return drivers are different enough to diversify when conditions turn.

Reconsidering the Defensive Allocation

If the defensive allocation no longer defends, the question is what to hold instead.

Most of the portfolio’s risk still comes from equities. Although stocks represent 60% of the capital, they account for roughly 89% of the portfolio’s risk. That concentration has become more pronounced. Today, the ten largest companies in the S&P 500 represent more than 40% of the index, margin debt has surpassed $1.2 trillion, and valuations continue to reflect high expectations for artificial intelligence. None of this tells us when markets will turn. High valuations alone have rarely ended a bull market; markets don’t die of old age. But when risk becomes increasingly concentrated, reducing exposure before conditions change is often easier than reacting after they do.

The next question is where that capital should go. The instinct is to move it 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.

Many institutional investors have responded by looking beyond traditional bonds for part of the defensive allocation. J.P. Morgan frames it as diversifying the diversifiers, recommending an allocation to diversified alternatives to reduce a portfolio’s dependence on the stock-bond correlation holding; BlackRock makes the parallel case for rebuilding the bond sleeve around an uncorrelated, alternative return stream. Fidelity’s managed-account business reaches a similar conclusion from the bond side: it funds the bulk of its diversifier allocation — alternative investments among them — out of traditional bonds, on the view that bonds hedge poorly when inflation is rising. Many institutional investors have responded by reallocating a portion of the fixed-income sleeve — typically 10% to 20% — into strategies whose returns are less dependent on interest rates and equity markets.[ii]

Not All Alternatives Solve the Same Problem

“Alternatives” cover a wide range of investment strategies, but they are not all trying to solve the same problem. For investors reconsidering part of the traditional bond allocation, the important thing to consider is the role the strategy is expected to play in the portfolio.

Insurance

Some strategies are designed primarily as insurance. Tail-risk hedges, such as index puts or VIX-based strategies, can provide meaningful protection during sharp market declines. The trade-off is cost: maintaining that protection can weigh on returns over a full market cycle.

Return-seeking alternatives

Private equity, private credit, and similar strategies — can generate attractive returns, but they often remain closely tied to equity or credit markets. They may improve return potential without materially changing how the portfolio behaves during periods of stress.

Ballast

Some strategies are designed primarily as portfolio insurance. Tail-risk hedges, such as index puts or VIX-based strategies, can provide meaningful protection during sharp market declines. Like any form of insurance, that protection comes at a cost. Maintaining it over long periods can weigh on returns because the premium is paid whether or not the protection is needed. The distinction between portfolio insurance and portfolio ballast becomes important here. Insurance is designed to respond to specific market events, while ballast is intended to strengthen a portfolio across a much broader range of market environments.

The Properties That Matter

Not every ballast strategy is suitable for replacing part of a traditional fixed-income allocation. Choosing the right one starts with understanding the job it is expected to do. Because the reallocation comes out of fixed income, not equity, the correct yardstick is high-quality fixed income, not the S&P 500. An investor reallocating 10–20% of the bond allocation is not trying to replace the return potential of equities. The objective is to replace the role the 40% was originally meant to play. Measured against that objective, investor my consider the following characteristics.

• Low volatility, comparable to high-quality fixed income rather than equities. The purpose of this allocation is stability. Replacing part of the bond allocation with a lower-volatility, absolute-return strategy can improve the portfolio’s overall risk-adjusted profile.
• Low correlation to equities, comparable to high-quality fixed income rather than equities. The purpose of this allocation is stability. Replacing part of the bond allocation with a lower-volatility, absolute-return strategy can improve the portfolio’s overall risk-adjusted profile.
• Seek expected returns across different market environments. Unlike portfolio insurance, which is expected to lose money outside periods of market stress, ballast should seek returns broadly comparable to high-quality fixed income in normal markets while retaining the ability to generate positive returns when equities decline.
• Return drivers that are genuinely independent of both interest rates and broad equity markets, so the diversification holds across different market environments rather than depending on a single macroeconomic regime.

Ultimately, these strategies should be judged against the role they are intended to play. For a replacement to part of the traditional bond allocation, success means delivering returns comparable to high-quality fixed income while remaining genuinely independent of equity risk, particularly when markets come under pressure.

Applying Uncorrelated Alpha

After decades of evaluating portfolio risk, we started with a simple question: if part of the traditional bond allocation no longer provides the diversification investors expect, what should replace it?

The result is a portfolio built around specialized institutional managers whose returns are intended to come from independent sources rather than broad market direction or the interest-rate cycle. That philosophy shapes both manager selection and portfolio construction.

• Independent return drivers. Rather than holding long-only fixed income whose returns depend on falling interest rates or compressing credit spreads, the portfolio allocates to specialist managers running market-neutral and relative-value strategies. The objective is to build return streams that are less dependent on the direction of either equity or bond markets.
• Manager selection under stress. Traditional fixed income carries both duration and credit risk, and both can turn against the portfolio at once. Manager selection emphasizes differentiated sources of return and how those strategies have behaved across different market environments, including periods of significant market stress.
• Correlation is measured, not assumed. One of the lessons of recent years is that historical relationships cannot be taken for granted. For that reason, correlation is evaluated across different market environments rather than assumed to remain stable over time. The objective is to preserve diversification when it is needed most.
• Strengthening the defensive allocation. Replacing part of a correlated fixed-income allocation with an absolute-return profile is intended to broaden the portfolio’s sources of return while reducing its dependence on interest-rate exposure alone. The goal is to pursue returns comparable to those investors have traditionally expected from high-quality fixed income, but through different sources of risk.

Rather than replacing equities or fixed income, it is intended to complement a traditional portfolio by providing an additional source of return that is less dependent on the same factors driving conventional stock and bond allocations.

For decades, the strength of the 60/40 portfolio came from the relationship between stocks and bonds. Recent years have shown that relationship cannot be taken for granted. Rebuilding the defensive allocation means looking beyond traditional asset classes and focusing instead on return drivers that remain genuinely diversified across different market environments.

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David X Martin is the CEO and CIO of Arctium Capital Management. Connect with him on LinkedIn here.

Enrico Dallavecchia is the President and COO of Arctium Capital Management. Connect with him on LinkedIn here.

*Any views expressed in this article are those of the author(s) and do not necessarily represent those of EFSI.

[i] 60/40 portfolio: a hypothetical portfolio of 60% S&P 500 Total Return Index and 40% iShares 7–10 Year Treasury Bond ETF (IEF), rebalanced monthly, for illustrative purposes. Statistics computed from monthly total returns, January 2016–December 2025. Real return deflated by U.S. CPI-U (All Urban Consumers, All Items, BLS), year-end (December/December) basis. Volatility is the annualized standard deviation of monthly returns. Correlation is the Pearson correlation of monthly total returns over the stated sub-periods. Risk contribution is each sleeve’s share of portfolio return variance, computed from the 2016–2025 covariance matrix at 60/40 weights. Bloomberg U.S. Aggregate figures computed from the same monthly dataset. This portfolio is not an investable index or an actual account which uses a broad investment-grade aggregate for its fixed-income component.

[ii] Industry sources. Fidelity, The New Diversification; Vanguard, Portfolio Perspectives (Vanguard for Advisors); BlackRock, A bond alternative for the new era of investing; J.P. Morgan Asset Management, On the Minds of Investors.