Investor Bondage: The End Of The 60/40 Portfolio?
When Mike Tyson was asked if he was concerned about Evander Holyfield’s fight plan for their impending match, he said: “Everyone has a plan until they get punched in the mouth.” For bond investors, the recent rout must feel like getting punched. The no-brainer asset allocation of 60/40, equities and bonds, has, for the past 40 years, returned a compound annual growth rate of 10.2 per cent (U.S.).1
Sadly, that kind of return may be a quaint artifact—like wall-to-wall shag carpets and avocado-coloured kitchen appliances. 70/30? 60/40? 50/50? Good luck. In today’s environment of low interest rates, high asset valuations, and probable rising inflation, future returns from the traditional balanced portfolio will likely be much lower. (More on this later.)
Goodbye To All That
One popular asset allocation rule is to subtract one’s age from 100 to set the equity allocation. For example, a 60-year-old should aim for 60 per cent sovereign (risk-free) bonds and 40 per cent equity exposure. The rationale for a higher bond allocation is to have a predictable and secure source of income, as well as ballast during times of high market volatility.
During market drawdowns, sovereign bonds tend to outperform as investors dump equities in a flight to quality. Bonds provide diversification and reduce portfolio risk, such as sequence of returns risk, whereby investors are forced to raise cash in a falling market and incur a permanent capital loss, potentially damaging the long-term viability of their portfolios. According to JPMorgan, balanced mutual funds manage nearly US7.5 trillion globally, evidence of their enduring popularity.2
With the increase in life spans and historically low bond yields, some retirement planners have revised the original guideline to 110 or 120 in order to boost equity exposure to maintain purchasing power. Others, like Ray Dalio of Bridgewater Associates, take a more extreme position regarding bond holdings. With real negative yields on sovereign bonds and high bond prices, he recommends investors shun this “impaired asset class” that carries a high risk of, not only not supplying sufficient income after inflation, but also bearing high capital risk. In a vivid illustration, Dalio charts how long it would take a bond investor to get her initial $100 investment back with interest. In the U.S., it’s 42 years. In Japan, it’s 450 years. These figures do not include maintaining buying power in the face of inflation. When inflation is factored in, the U.S. number jumps to 500 years. In Europe, you’d never get your buying power back.3
A 2021 survey by Credit Suisse reports that the likelihood of “substantial and protracted negative real return has never been greater in the bond market.”4 What’s an investor to do?
Out of Bonds
Eliminating bonds entirely seems extreme. To maintain a weighting to fixed-income and to hedge interest rate risk, Richard Bernstein, chief executive and chief investment officer of U.S.-based Richard Bernstein Advisors shared his suggestions on a recent episode of Wealthtrack:5
Shorten Bond Duration limit interest rate risk and a lower total return by choosing shorter duration sovereign bonds with maturities of five years or less. Due to the convexity of the yield curve, bonds of longer duration (10+ years), are more sensitive to changes in interest rates. Although the U.S. Federal Reserve has promised to keep short-term interest rates low until at least 2024, longer-term Treasuries are gradually ticking up, indicating an expectation of higher inflation. In March, the 10-year Treasury Note hit 1.7% and the 30-year rose to 2.47% causing their prices to fall. (Bond yields move inversely to bond prices.) Longer maturity bond prices have dropped more than 14% since 2021, close to the worst quarter since the late 1980s.6
Bernstein applies the concept of duration to equities as well. Long duration equities typically carry high price/earnings (P/E) ratios. For example, a company with a P/E of 50 represents 50 years of earnings, assuming no growth. During periods of inflation, long duration equities tend to underperform compared to short duration companies.
Consider Corporate Debt
The good news is, if interest rates go up, it means the nominal economy is improving and this will pull up smaller, more marginal companies whose bonds are mispriced because of the perceived risk of bankruptcy. Selective buying further down the quality curve can generate higher yield with reasonable risk.
Get Out of Town
Bernstein touts the improving fundamentals, favourable valuations, and lower volatility of Emerging Market (EM) bonds. Before you fall out of your chair, Bernstein’s thesis is, since these bonds are backed by local governments, EM bonds have a lower default rate compared to U.S. high-yield bonds. Investors reaching for yield should tread carefully, however. Of late, a stronger U.S. dollar and higher U.S. yields are dampening enthusiasm for developing markets which must service their U.S. debt. EM countries whose growth lags the rate of interest on debts are especially in a bind.8
Inflation Hedge
Bernstein argues that the markets can become destabilized, not by the absolute level of inflation, but by a mismatch between our expectations and the reality. If everyone expects a CPI of 2.3% and it comes in at three per cent, the jump will rattle investors. To hedge inflation risk, Bernstein recommends a tilt toward cyclical sectors such as financials, small/medium-sized businesses, commodities such as oil, materials, energy, copper, as well as countries which produce commodities.
Alternative Reality
Other ways to replace government bond income is through alternative assets such as private equity, infrastructure, real estate, inflation-linked bonds, and equities with growing dividends. However, it must be noted that none of these are risk-free assets like government bonds.
Lower Returns For Longer And The COVID Test Drive
According to a recent report by Credit Suisse, Baby Boomers, Gen X, and Millennials have all done quite well with average real returns of at least five per cent on equities and 3.6% on bonds. Gen Z will not be as fortunate with expected real returns of minus 0.5% on bonds and 3.5% on equities for an annualized return of two per cent on a 70:30 equity/bond portfolio.8
For those retirees looking to fund a 30-year post-work period, low future returns may require them to work a bit longer or part-time after age 65—or to lower their spending expectations. Unsure about how much you will spend in retirement? Pandemic lockdowns provide a clue. Just as retirees tend to spend more earlier and less later as travel, hobbies, dining out, and cultural events naturally taper off, during lockdown many people of all ages discovered how much their day-to-day expenses dropped when they stayed home!
Bottom Line
Despite the risks associated with equities, since 1900 they have vastly outperformed bonds and T-bills to the tune of 4.4% over bills and 3.1% over bonds per year. According to the Credit Suisse Global Returns Yearbook 2021, an investment of U.S.$1 in equities, with reinvested dividends, would have grown in purchasing power 2,291 times over 121 years, representing an annualized real return of 6.6%. For bonds and bills the return multiples were 12.5 and 2.6 times, for annualized real returns of two per cent and 0.8%, respectively. (Canada: real annualized returns from 1900-2020, just under six per cent on equities; around 2.1% for bonds; and around 1.6% for bills.) Furthermore, the longest drawdown of cumulative real returns for U.S. equities was 16 years from 1905-1920. In other words, if an investor held equities 17 years or more, she would be assured of a positive return. As a point of comparison, to be assured of a non-negative real return from U.S. government bonds, the holding period would need to have been 57 years.9
While the future may not be as kind to investors in U.S. equities, this extensive data makes a good case for the relative real safety of holding a diversified equity portfolio composed of quality companies which grow their dividends, over the perceived safety of government bonds.
Rita Silvan, CIM is a finance journalist specializing in women and investing. She is the former editor-in-chief of ELLE Canada and Golden Girl Finance. Rita produces content for leading financial institutions and wealth advisors and has appeared on BNN Bloomberg, CBC Newsworld, and other media outlets. She can be reached at rita@ellesworth.ca.
1 https://www.ft.com/content/fdb793a4-712e-477f-9a81-7f67aefda21a
2 https://www.ft.com/content/257839a9-b6b6-4bc4-97d1-e20df87acef2
3 https://www.linkedin.com/pulse/why-world-would-you-own-bonds-when-ray-dalio/
4 https://www.credit-suisse.com/ca/en.html
6 https://www.ft.com/content/55eb123d-b45e-4c30-a5e8-c026309cb482