Lately we’ve been taking a long, hard look at the “40” in the classic 60/40 portfolio: 40% high-quality bonds, with the rest (60%) going into the largest stocks in US and foreign markets. The 60/40 allocation to high-quality stocks and bonds has worked remarkably well since the 1980s, through markets good and bad, especially for those in or near retirement. It has been a fantastic way to accomplish all these beneficial things: (1) reduce risk; (2) participate in sizable market gains; and (3) capture income. But the times they are a ‘changin, as Bob Dylan crooned.
The Covid-19 crisis has ushered in an era of ultra-low interest rates (see numbers below), and it seems they could stay at current low levels for a while. The Federal Reserve, which cut its key short-term lending rate to near zero in March 2020, is indicating it will stick with a zero-rate program for years to come. We are not surprised by this, given the great deal of government and corporate debt, which has increased dramatically this year to offset the impact of Covid-19.
Near Record Lows: Key US Rates
(Sept. 4, 2020)
|Federal funds rate: 0.09%||US money market average: 0.11%|
|10-year Treasury yield: 0.72%||30-year Treasury yield: 1.47%|
|15-year mortgage: 2.54%||30-year mortgage: 3.07%|
2020 Could Be a Turning Point
Bonds have been fantastic risk-adjusted performers over the past 40 years (see below), due to a combination of income and falling interest rates. But given where US interest rates are now, bonds are not likely to provide the income they did even in 2018/2019. And the potential for capital gains is also limited. It is possible, of course, that US interest rates will drop even more, to below zero. But the Fed has said it does not foresee this, given that the US economy continues to recover from the impact of Covid-19.
What we see: bonds offering very little income and limited capital gains. What’s more, should interest rates rise as the economy comes out of the Covid-19 recession, bonds could suffer significant losses.
Total Return of US Stocks and Investment-Grade Bonds
(through Aug. 31, 2020, annualized*)
|S&P 500||Bloomberg Bond Aggregate|
|2020 through Aug. 31||9.7%||6.9%|
|Past 10 Years*||15.1%||3.7%|
|Past 40 Years*||11.6%||7.6%|
This argues for a new look at bond allocations. We still think high-quality bonds are a must for virtually all portfolios. But we think it is now worth questioning how much to allocate to bonds going forward, and within bonds, what types of bonds? Below are adjustments we are considering for LNWM portfolios in order to optimize risk-adjusted returns during the 2020s (based on client finances, risk tolerance and investment horizon):
***Increase allocation to equities. A long-term investor whose finances can withstand the higher volatility of stocks, might go from a 60/40 portfolio to a 70/30. Stocks offer better protection against inflation than bonds, as corporate profits and dividends tend to rise over time along with prices. But given record high stock prices, this is a shift that should be done strategically over time.
***Diversify bond holdings. The liquidity crunch in fixed income markets was severe this spring but it subsided as the Federal Reserve stepped in to buy bonds rated below investment-grade. This has created new opportunities in lower-quality, higher-yielding debt, which can be a good diversifier to US Treasuries. In our portfolios, we already have a stake in multi-strategy funds, which have the ability to invest in a wide variety of debt.
***Add private market investments. One example here are private direct lending funds. Instead of banks funding corporate buyouts, private funds are now a main source of lending for these types of transactions. The funds work with groups seeking to buy companies with low valuations and/or with the potential for restructuring, aiming eventually to sell the companies at a profit or take them public. Direct-lending funds are open only to accredited investors and typically have a lock-up period for capital. After doing extensive due diligence, we are now suggesting one such fund for those LNWM portfolios for which it is appropriate.