Should bonds continue to be a part of the traditional 60/40 balanced portfolio, given their low yields and presumably low future returns?
That phrasing understates the matter. Ten-year US Treasuries now yield 0.70%. With the 10-year inflation rate expected to be 1.64%, the note’s miserly payout implies that if inflation meets investor expectations, the receipts from 10-year Treasuries will trail the rise in the cost of living by almost 1 percentage point per year.
(As the goal of investing is at the very least to preserve purchasing power, if not to outright increase it, then one could legitimately wonder if Treasuries at today’s prices are “investments.” Perhaps they should instead be regarded as an electronic version of mattress stuffing.)
To be sure, that 0.70% payout will look relatively attractive if yields fall further. In such a case, the Treasury note would increase in price, thereby boosting its total return. The maths, though, remain unfriendly. For example, if Treasury yields were to hit zero in the year 2025, the 10-year Treasury would be worth $1,035. Its total return over that five-year period would be 1.4% – still below the level of expected inflation.
The question as to whether the traditional 60/40 allocation still applies is legitimate. The underlying assumption of balanced portfolios is that the bond allocation, although conservative, will also be profitable. That assumption faces serious doubt.
Emerging Market Debt
Not really. Most US domestic bond-fund categories yield more than Treasuries, and thus likely have better long-term return prospects. However, as bond credit spreads are relatively tight, with the yields for BBB corporate bonds being a moderate 1.8 percentage points higher than those of Treasuries, the reward for assuming credit risk isn’t great. In addition, swapping government bonds for corporate bonds reduces diversification, since lower-quality securities move more in tandem with the stock market.
Heading overseas is no solution, as US government yields exceed those of most other developed markets. For example, Japan’s 10-year government bonds yield a piddling 0.02%, while those of Germany, France, the Netherlands, and Switzerland have negative payouts. Unless the dollar weakens, thereby providing the international-bond investor with capital gains, the mattress would be an investment improvement! (Assuming, that is, that the bedroom doesn’t burn.)
One possibility, which I mention tentatively, is emerging-market government bonds, which yield about 4% and which for the major markets are very likely to be money-good. (China won’t default anytime soon.) Unfortunately, they tend to lose value when the global stock market dives, so they aren’t particularly good diversifiers.
Can Alternatives Replace Bonds?
Perhaps they can. I have long been sceptical of alternative investments, such as market-neutral, managed-futures, or currency funds, because their performances haven’t justified their additional risks. For example, among funds, those three categories all failed to appreciate by even 1% per year over the past decade (to the end of August, 2020), while intermediate-term core bonds funds gained 3.6% per year.
That maths has changed. True, it’s unclear whether alternative investments will beat bonds in the future, as opposed to joining them by treading water in nominal terms, while losing money in real terms. It could be, as has occurred over the past decade, that the profitable alternatives were cushioned versions of the stock market--long-short equity and options-based funds--while the alternatives that actually offered diversification went nowhere. That would be no help.
Nonetheless, in contrast with my earlier views, I would now consider using alternatives with balanced funds. Not as complete substitutes for bonds, but instead as partial replacements, along with other investments. For example, rather than the conventional blend of 60% equities/40% bonds, I might hold 60% equities, 16% bonds, 8% alternatives, 8% gold futures, and 8% cash. (This counsel is purely hypothetical, as I neither own a balanced portfolio nor advise clients.)
The Search for Diversification
When holding a diversified portfolio of risky investments, one hopes that each asset class will pull its own weight. Otherwise, one could just own Treasury bills, which over history have posted a flat long-term real return, with their nominal performance essentially matching the rate of inflation.
Exceptions could be made for assets that consistently zig when the rest of the portfolio zags, thereby making the benefit from diversification so powerful that it can overcome modestly (but not strongly) negative returns. But Treasuries do not possess that attribute, as they tend to slide along with the stock market when inflation unexpectedly rises. High-quality bonds are an excellent hedge against recessions – but not necessarily against other causes of stock market declines.
That said, one can only work with what the financial markets provide. Forty years back, investors could select from a wide variety of securities that offered high yields – bonds of all flavours, along with most stocks. They enjoy far fewer such opportunities today. In such a climate, buyers may swallow hard and continue to own Treasuries, solely to achieve diversification. Such a decision would make sense. However, as previously suggested, they probably will wish to cut their allocations, given today’s prices.