In 1952, a University of Chicago professor named Harry Markowitz published a Journal of Finance article inauspiciously titled “Portfolio Selection.” Dr. Markowitz argued, using mathematical and statistical methods, that assets (ie. stocks and bonds) could be combined together to produce a portfolio that optimized risk and return. This analysis would go on to win Dr. Markowitz a Nobel Prize and is viewed by many as the birth of the 60-40 portfolio (consisting of 60% stocks and 40% bonds) which has become a cornerstone allocation of investment advisors ever since. Portfolios may be allocated to other blends (70-30, 80-20, and so on), but “60-40” is the moniker that implies a portfolio made up of a combination of stocks and bonds.
The theory was this: we know stocks can provide attractive returns over long periods, but they can be volatile. By adding bonds to the mix, we may give up some long-term return, but we get lower volatility, and more importantly, non-correlated volatility – meaning bonds typically act as a shock absorber precisely when equities struggle.
That was true until this year.
While it’s obvious that equities have declined significantly this year due to inflation, interest rates, and recession fears, bonds have not provided the ballast they did in past equity selloffs. In fact, this has been the worst year for bonds in over 40 years.
Looking at the chart, bonds have only had 5 down years in the past 42, and more importantly have provided solid returns during the roughest periods for equities – particularly the early 2000s tech crash and the 2008 financial crisis. But with stocks down over 20% this year and bonds also down 15%, is the 60-40 portfolio obsolete?
A quick Google search will find that we are not the first to opine on this topic. Just last weekend, Barron’s trotted out the headline: “The 60-40 Portfolio is Dead.” Most of these articles land on one of two conclusions, that 1) the 60-40 portfolio will “snap back” based on historical patterns given this unusually anomalous year or that 2) investors should be looking to add alternative income streams or asset classes to replace the bond component. While some elements of both these arguments may have merit, few look at the relative forward attractiveness of bonds – do they make sense in a portfolio right now?
To answer this, we need to look out the front windshield, and not in the rear-view mirror. Bond yields have had one of the most rapid increases in history this year which have driven prices, and thus returns, down (bond yields and bond prices are inversely correlated). The key question for bonds is: will rates continue to increase (sending bond prices down further) or have they found an adequate level?
This answer will hinge on the path of future inflation. Historically, bonds have provided some level of return above the rate of inflation. That was true before the Fed began suppressing rates following the 2008 financial crisis and then this year as inflation was ignited. The grey line in the chart below shows the “real interest rate” over time – the return that bonds have provided after the impact of inflation.
Based on this chart, the average bond yield above inflation has been just over 2% (2.13%, red circle above). To get the “right” yield on bonds currently, we need to know what inflation will be in the future. This is the tricky part. Right now inflation is abnormally high at 8%, but most of the leading indicators indicate that this should start to come down over the course of the next year as the Fed rate hikes start to bite. The Fed is targeting 2% inflation long-term. Bond investors, using inflation-linked bonds as an indicator, are implying inflation should average around 2.5% over the next 5-10 years.
So, to get to an estimate of where current bond yields should be, we add the real rate (2% historically from the chart) plus the long-term rate of inflation, let’s say 2.5%, to get to an all-in yield of 4.5%. Bond yields today are exactly in that range as the current consensus for the terminal Fed interest rate in 2023 is 4.75%. This math would suggest that bond yields are somewhere around fair value today, and if so, then a good part of the damage to returns is in the rear-view mirror. Admittedly, this is an imprecise science. Real yields and inflation can fluctuate meaningfully around their “average.” Barring continued runaway inflation, bonds should likely resume their role as yield producer and portfolio ballast going forward based on these long term averages. Yes, interest rates could tick marginally higher and hurt short term returns, but the long term risk/reward setup for bonds looks increasingly attractive here.
Will bonds see the types of total returns we’ve seen over the past 40-years during the historic bull market? Likely not. But that doesn’t mean they should be shunned in a diversified portfolio going forward – the maxims established by Markowitz have stood the test of time and bonds can still fulfill a role as a diversifying, risk-reducing asset inside any portfolio. The reports of bonds’ death have been greatly exaggerated.