by Dr. Charles Lieberman
Virtually everyone appreciates that Treasury bonds are close to all-time record low yields, but how should investors adapt to that fact? Bonds still have a legitimate role to play in any portfolio, but it is appropriate for every investor to revisit their allocation to bonds.
Professor Jeremy Siegel of Penn’s Wharton School has stated that 75/25 is the new 60/40, suggesting that institutional investors who historically allocated 40% of their portfolios to fixed income should now reduce that allocation to just 25%. Personally, I don’t care for such simplistic straight jacket allocation schemes, because they fail to take any of a myriad number of key factors into account that people are different. If 60/40 is appropriate for one, such an allocation provides little guidance as to whether it is appropriate for anyone else, since we all have different investment objectives, different risk tolerance, different ages, family obligations, wealth levels, health prospects, and I could keep going. There is simply nothing holy, or even correct, about a 60/40 allocation. And we all react differently to today’s political, economic, and health environment. Our portfolios should reflect those differences.
Still, how should our portfolios adapt given how economic and investment conditions have changed? In that one key respect, Siegel is guiding towards a larger allocation to equity and a reduced allocation to fixed income. Why?
To start, an investment in long dated Treasury bonds today will produce a lower return and it will entail considerably more risk than has been the case for bonds historically. A sizable fraction of all Investment Grade bonds yield less than 1%. Interest rates are likely to rise someday. When rates do rise, Treasury bond prices will fall. The Fed has a 2% inflation target, but has publicly stated it will allow inflation to exceed 2% for periods of time. If inflation does get to the Fed’s objective—(do you really want to bet against the Fed?)—it is impossible to think 10-year Treasury bonds will yield less than 0.70%, as they do today. Rather, if 10-year Treasuries rates yield a more normal 100 basis points above a 2.5% inflation rate, the value of that bond will fall by roughly 23 points, a much larger loss than all the interest the bond will pay over its 10-year life. Moreover, any buyer of Treasury bonds today will most certainly earn a negative return after inflation, yet must still pay taxes on the interest they do earn. And if inflation surges as some believe, although we do not expect any such surge, bond purchasing power will be decimated. These days, bonds offer plenty of risk with little return.
Higher yielding, high quality fixed income alternatives do exist. Our fixed income approach carefully selects investment grade securities yielding significantly more than the 10-year Treasury with lower interest rate risk. One could also choose to add some higher yielding and non-rated fixed income securities for investors with a bit more risk tolerance. We are doing our own credit analysis and managing to find bonds that we believe are mispriced or at least cheap, so our yields are meaningfully higher than is available from Treasury by taking some limited incremental credit risk. Adding a small dollop of credit risk can materially boost yield substantially. Our fixed portfolios are generating anywhere from 3 to 4 times as much as the 10-year Treasury with less duration risk. Such returns in a fixed income portfolio provides comfort when the economic outlook is still unclear, the timing for a vaccine is still unknown, plus we have an election upcoming, so the stock market is sure to remain volatile.
Owning stocks ensures investors will be treated to a roller coaster ride over their holding period, but they are more likely to earn a return on investment that compensates them for that volatile experience. Nothing is guaranteed, of course, but consider an investment in our Balanced 4% target portfolio. It provides a current yield more than the five times the yield of the 10-year Treasury, yet also offers upside potential over the 10-year life of the bond. Absolute returns in stocks may be lower over the next 10 years than historically. Even so, the stock market’s performance should easily outpace the bond market, even if the margin by which stocks outperform bonds is not out of line with past experience.
So why would an investor even consider owning any bonds? Bonds do provide a clearly defined date certain return, and if they are Treasury bonds, they also avoid all default risk. Such certainty is valuable. It enables many investors to sleep well at night. Moreover, investors do not need to sacrifice all of their return to get this certainty. Rather, they can allocate as much of their portfolio as they need to bonds to be able to tolerate more risk on the equities they own. Owning bonds provides a safety net. If the economy and the stock market meltdown, bond values should hold up quite well and give investors the capability to buy depressed stocks at lower prices to await recovery.
Unfortunately, the discussion above must be generic, since every investor has those different considerations to take into account: different risk tolerance, investment objectives, age, wealth, etc. But given how much interest rates have declined, every investor should discuss with their financial advisor if they should reduce their fixed income allocation.