For most of the past decade, investors searching for income in the fixed income market have been hard-pressed to find any solutions without taking on significant credit risk. Due to the Federal Reserve’s multiyear zero interest rate policy, interest rates on nearly all fixed income instruments have been at historically low levels. As an example, Treasury Bills (Treasury securities with less than one-year maturities) were yielding well under 1% at the end of 2021 and, in many cases, nearly zero.
At the same time, inflation was beginning to creep higher, and fixed income investors faced a near guarantee that they would lose purchasing power on their principal investment. In June 2021, we penned an article titled “60/40 Hindsight: Is It Time to Reconsider One of the Key Tenets of Portfolio Management.” One of the key points we posited was that given fixed income yields were being suppressed in the markets, one could question the efficacy of employing the 60/40 investment model (60% equities, 40% bonds) to help reduce portfolio risk.
As background, the idea behind the 60/40 model was that investors could realize benefits from allocating a portion of their portfolio to bonds, which could provide a ballast to the risk engendered from their equity investments. When the economy is strong and the equity markets are rising, the potential drag from the bond investments would limit the portfolio upside performance. But more importantly, if the economy enters a recession and stock prices begin to fall, the decline in interest rates would benefit the bond holdings and help offset declines in the equity portion of the portfolio. By acting as a ballast to the portfolio and generating yield, the bond investments could help smooth out returns. Moreover, the portfolio would be able to generate sufficient income such that investors would not be forced to sell stocks at depressed prices.
Indeed, the 60/40 model worked fairly well and consistently for over three decades. Thus, it was considered to be a viable solution to balance portfolio risk and could serve as an investment strategy that could perform well through all parts of the economic and market cycles.
The 60/40 Breakdown
In our June 2021 article we expressed our doubts as to whether the 60/40 model would indeed prove effective going forward. While the unprecedented actions and policies of both the federal government and the Federal Reserve in the wake of COVID-19 pandemic led to stabilization of the economy and the markets, we saw clouds of uncertainty on the horizon. With regard to risk management, we became concerned that the eventual normalization of the financial markets, particularly interest rates, would cause a breakdown in the 60/40 model’s efficacy.
Little did we know how rapidly those concerns would become validated in 2022. Advocates of the 60/40 model have been sorely disappointed with the performance of bonds this year in light of the weak equity markets across the globe. Unless one’s bond allocation consisted of very short-dated fixed income securities, returns on bond investments have been abysmal this year, with many fixed income investors suffering double-digit losses. Even on the short end of the maturity spectrum, the SHY (iShares 1-3 Year Treasury Bond ETF) is down approximately 5% this year on a total return basis.1 On the longer end of the maturity spectrum, the TLT (iShares 20+ Year Treasury Bond ETF) is suffering losses of over 30%2, surpassing the losses on the S&P 500 index. Thus, it appears that our hypothesis last year has indeed been borne out.
But now that the interest rate environment has changed so markedly, is it time to once again consider the value of the 60/40 model? Moreover, with inflation at the highest levels in four decades, does it pay to wait until interest rates stabilize before once again reengaging the 60/40 strategy?
There Is an Alternative (Again)
The acronym “TINA” (“There is No Alternative”) became the rallying cry on Wall Street in recent years and explains why some investors have shunned bonds. Seeing negligible income generation and limited opportunity for capital appreciation, many believed that there was no plausible alternative to investing in stocks. Therefore, these investors felt compelled to overweight stocks to generate healthy long-term positive performance. Indeed, stocks performed quite well following a brief slide in early 2020. In the meantime, bonds continued to trade at historically low yields.
Underneath the exuberance in both the equity and fixed income markets was a key economic concern that has been ignored for many decades: inflation. The magnitude and stickiness of growing inflationary pressures forced the Federal Reserve to finally tighten monetary conditions this year at an accelerated pace.
Given the extreme sell-off in the fixed income markets and the attendant surge in yields, bonds have once again become a more compelling alternative to equities. Yields across the maturity spectrum have risen significantly. Compared to conditions a year ago, bonds offer higher yields and lower risk attributes than they have in quite some time. Although inflation rates have yet to cool off, the vast majority of fixed income securities now offer yields well in excess of the Federal Reserve’s long-term inflation target of 2%. If the Federal Reserve is successful in achieving that goal, we believe that bond investors will have the opportunity to generate “real returns” (returns in excess of inflation) and perhaps even enjoy some capital appreciation.
A 60/40 Revival?
In contrast to 2021, a 60/40 portfolio of stocks and bonds now can generate more meaningful income, offer upside appreciation, and could once again provide future downside protection to further declines in the equity markets. Given the current weaker macroeconomic environment and the potential for recession, incorporating an allocation to fixed income securities could once again prove to be a robust strategy.
History would suggest that there is further potential downside risk in bonds. In the 1980s, Federal Reserve Chairman Paul Volcker raised the Federal Funds rate to over 20% (currently at 3%-3.25%) before finally “slaying the inflation dragon.” But we believe that there is a reasonable chance that the Federal Reserve will begin seeing success on the inflation front and decide to pause interest rate tightening. If that scenario plays out in early 2023, that could mark the end of the bond market rout. In that case, the 60/40 investor will again be in the driver’s seat.
The views presented are those of the authors and should not be construed as personal investment advice or a solicitation to purchase or sell securities referenced in this market commentary. The authors or clients may own stock or sectors discussed. All economic and performance information is historical and not indicative of future results. Any investment involves risk. You should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice. All information is obtained from sources believed to be reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or from the results obtained from the use of such information.
Jonathan D. Caplan, a former Wall Street executive, is president and founder of wealth management firm Caplan Capital Management, Inc., with offices in Highland Park and Hackensack. He holds a BA from Yeshiva University and an MBA in finance from New York University Stern School of Business. You can find other recent investment articles by Jonathan at www.caplancapital.com/blog.
1 iShares 1-3 Year Treasury Bond ETF | SHY, https://bit.ly/3gEi6bS
2 iShares 20+ Year Treasury Bond ETF | TLT, https://bit.ly/3zgjmsh