Written by Stephen Ostrofsky, CFP®
Most long-time investors can remember when interest rates were at a level which made bonds a viable asset class in portfolio allocations for most investment objectives and risk tolerances. As an asset class bonds provide portfolio stability as a reliable source of income and a hedge against stocks declines during recessionary periods. The inverse correlations between the two pillars of portfolio construction over longer periods of time are deemed to provide better risk-adjusted portfolio returns. This all sounds great, why has the pursuit of this strategy, a “holy grail”, been so out of favor? Since the Mortgage Crisis in 2009, the Federal Reserve’s Federal Funds Rate remained artificially low through various monetary policy tools. This monetary policy resulted in historically low interest rates which produced overvalued bonds relative to stocks and negative interest rates for sovereign debt throughout the global economy.
Over time price distortions have led to mispriced securities which resulted in valuation adjustments to the downside for both stocks and bonds in 2022. In March 2022, the Federal Funds rate was .50%, a year later the rates were 4.75% which is the result of a fight against inflation from the explosive growth in the M2 Money Supply during the COVID Pandemic. The result of the recent rise in yields has pressured bank balance sheets from declines in bond portfolios and retail bond investors who suffered losses in pursuit of higher yields.
In the wake of the 2022 reset in lower valuations for stocks and bonds, it’s now possible to seek total returns in the high single digits by investing in core bonds and proven dividend-paying stocks without taking undue risk or reaching for yield. The 60/40 paradigm now offers bond yields at a reasonable level to provide the “cushion” to undulating stock prices which will be needed during economic cycles. Our best argument for the current ascension of the once lauded 60/40 portfolio asset allocation strategy is based on the following observations.
First, the correlation between stocks and bonds experienced in 2022 was an outlier, due to historically low interest rates and overvalued bond prices. In 2022, the performance for a 60/40 portfolio allocation was the only time in the past 45 years that both stocks and bonds declined in tandem for a full calendar year.
Secondly, bonds now provide attractive risk-adjusted current income returns. The recent aggressive Fed action has resulted in most classes of bonds offering significantly higher yields than a year ago. The historically low rates, since the mortgage crisis, meant that investors were not able to count on bonds to make much of a contribution to a portfolio’s total return. Now that bonds offer higher potential income today, investors may be able to take less risk with their equity investments and still meet their return expectations. This overall shift will contribute towards higher risk-adjusted portfolio returns.
Finally, stock dividends impact stock returns positively over time. Historically, dividend-paying stocks have tended to be less volatile than growth stocks. If a bond portfolio can provide mid-single digit returns or better, dividends can potentially contribute to an attractive overall return picture within a portfolio’s equity allocation — without taking undue risk. For income investors, it’s possible to seek total returns in the high single digits by investing in core bonds and proven dividend-paying stocks without taking undue risk or reaching for yield.
In Summary
The “60/40 portfolio” has long been revered as a trusty guidepost for a moderate risk investor—a 60% allocation to equities intended to provide capital appreciation and 40% to fixed income to offer yield and risk mitigation. To accept this investment paradigm, investors must recalibrate their expectations and come to terms with the reality that the stellar returns from stocks that they have become accustomed to are likely to be challenged by higher yielding alternative bonds. For many investors, an entrenched “what has worked will continue to work” mindset, might lead to wrong conclusions for your investment thesis.
Important Disclosures
True North Financial Advisors provides “rules-based” investment strategies in commission-based and fee-based discretionary investment accounts, designed to protect profits and limit losses. All investment strategies involve risk and may result in the loss of principal. Investors are encouraged to contact True North Financial Advisors for more details.
For help protecting your investment portfolio and generating the income you need in retirement, contact the investment professionals at True North Financial Advisors by calling 855-377-7526, to Set Your Own Course.
