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Go beyond core bonds: Reimagine the 60/40 portfolio

Low rates make it challenging to find yield. But there are other ways to maximize the “40” in your portfolio.

For decades, a 60/40 portfolio (60% stocks, 40% bonds)1 has served as the go-to allocation for long-term investors. Since the turn of the century, 60/40 portfolios have largely kept up with MSCI World Equity returns, with 40% less volatility. However, the traditional framework now looks problematic, as yields globally are hovering near zero. With core bonds offering negative after-inflation yields and limited diversification benefits, it’s time to reimagine the role of the “40” in your 60/40 portfolio.

Core bond challenge: Negative real yields, diminished diversification

Even at low yields, core fixed income still offers some protection. It remains a key diversifier we use to mitigate equity risk in client portfolios. But today’s environment presents fresh challenges, pushing us to find additional ways to diversify portfolios.  

We see two main headwinds for core bonds going forward: lower return expectations and diminished diversification benefits. Consider: If you bought an aggregate bond fund (a benchmark investment for low-risk income) in 2010, right after the global financial crisis (GFC), that fund would have delivered 50% in cumulative total returns as of year-end 2020. The vast majority of that return came from the yield on the underlying bonds. If you bought the same bond fund in today’s low rate environment, it would take you 38 years to earn a 50% cumulative total return, assuming yield was the only source of return. 

How low have yields gone? Across the developed world, bond yields have fallen below the expected rate of inflation. In the United States, the real yield (the nominal yield minus inflation) on the Bloomberg Barclays U.S. Aggregate Bond Index is -1%. Negative yields mean your bonds reduce your purchasing power—an unwelcome scenario for anyone’s portfolio.

What’s more, the diversification benefits of bonds have diminished. Traditionally, bonds have offered the potential to gain when stocks decline. But we estimate that 10-year U.S. Treasury bonds can appreciate only about 10% more from current levels. That’s paltry diversification potential compared with the turn of the century, when U.S. Treasuries had the potential to appreciate by 50%. The prospects for price appreciation are even more modest in the rest of the developed world.

40% of your benchmark is now eroding purchasing power

Bonds can only protect you so much as you approach the lower bound

Bond markets present another, more immediate, challenge: an expected rise in long-dated Treasury yields in 2021. Alongside a robust macroeconomic rebound, we expect 10-year U.S. Treasury yields to increase to 1.5% by the end of the year. Why is that a problem? Higher yields mean indices used as traditional portfolio ballast, such as Bloomberg Barclays Aggregate bond indices, are likely to deliver negative total returns as prices fall and interest rates rise.

We expect near zero total returns for core bonds

Maximizing risk-adjusted returns

Given the challenging outlook for bond investors, you need to be deliberate about your goals and risk tolerance. Ask yourself—what is the objective of the bonds in your portfolio? To help you answer that question, we leverage J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions (LTCMAs) to create a risk-return spectrum comprising public market fixed income products, such as Treasuries and investment grade credit, and other potential alternatives, such as real estate and REITs. As you move from the bottom left of the chart to the top right, return increases, but so too does volatility (risk). The bigger the circle, the higher the correlation to equities (less portfolio diversification).  

This is the broader risk-return spectrum needed to reimagine your 40%

From there, we optimize the variables to create the “best” portfolio mix (the highest risk-adjusted return for a given level of volatility). For this exercise, we are holding the 60% allocation to equities constant; in this way, the higher expected return, relative to a traditional 60/40 portfolio, is driven solely by changes to the composition of the 40% allocation. Critically, we use year-over-year volatility assumptions, so this portfolio is best suited for long-term investors. Here is what the results tell us:

A reimagined 40% allocation can optimize the risk/reward trade-off in the current low yield environment

If you are looking to get the best risk-adjusted return for a dollar invested (the highest risk-adjusted return anywhere on the efficient frontier), consider allocations to high yield municipals, bank preferreds and core real estate/infrastructure. Clearly, the tax advantages of high yield (HY) municipals and bank preferreds are important considerations. We note that HY municipals have lagged the overall rally post-COVID-19, particularly in the healthcare, higher education and transportation sectors, and they stand to gain considerably when herd immunity is reached. And HY municipals offer low default rates—an annual average of 0.7% since 1970, 75% lower than HY corporates.

As for bank preferreds, banks’ greater resilience allows us to feel comfortable going down in the capital structure for yield. For the six largest U.S. banks, a key measure of bank balance sheet strength, Tier-1 capital, is 65% higher than it was leading up to the GFC. And in Q2 2020, during the worst of the COVID-19 shock, those ratios declined by only 20 basis points (bps).

Core real estate and infrastructure generally offer distributed income from 4% to 6%, with a volatility roughly two-thirds that of the S&P 500.2 Just as important, private credit is undergoing a secular shift. Banks are retrenching from middle-market lending and focusing on larger issuance in the high yield market. Private capital is happy to step up to fill the void, but so far has been unable to keep up with demand. Certainly, investors are giving up public market liquidity when buying these assets, but we think higher private market yields are worth the switch.

If you are looking to augment yield and willing to withstand more volatility, consider allocations to REITs or dividend-paying stocks. REITs generally offer yields between 4% and 7%, but they’ve also been a sector with significant dispersion—a nearly 48% return difference between top- and bottom-quartile REITs since 2000. The REIT market is also unique in that public markets can place a very different value on real estate than private property markets—often creating arbitrage opportunities. Active managers may be best equipped to capitalize on these unique market inefficiencies.

In public equity markets, the dividend yield on the S&P500 is higher than the 10-yr Treasury yield and the Bloomberg Barclays U.S. Aggregate. Since 2000, this has happened just two other times, and in both instances Aggregate indices were negative total return investments over the subsequent year (2013 and mid-2016 to mid-2017).

If you are focused on keeping volatility low, continue to rely on Aggregate indices and intermediate Treasuries, as they could still provide portfolio diversification benefits should the macroeconomic recovery prove less robust than we expect. 

You may also consider hedge funds. They can serve as valuable diversifiers in portfolios, with the potential to generate meaningful absolute returns without relying on traditional equity or credit risk. Historically, periods of rising interest rates have been good environments for hedge fund strategies that can benefit from higher volatility in fixed income markets.

Final thoughts

There’s no denying it’s a tough environment for core fixed income, requiring a rethink of the traditional 60/40 portfolio. There are challenges, to be sure. But you can find income and portfolio diversification in a wide range of asset classes and strategies. Think about your personal goals and risk tolerance, and discuss with your J.P. Morgan team about what reimagined 60/40 portfolio is right for you.

1. 60% MSCI Global Equities and 40% Barclays Global Aggregate.
2. Sources: FTSE, MSCI, NCREIF, FactSet, J.P. Morgan Asset Management. Global Infrastructure: MSCI Global Infrastructure Asset Index-Low Risk; U.S. Real Estate: NCREIF-ODCE Index; Global REITs: FTSE NAREIT Global REITs. Data is based on availability as of February 5, 2021.






S&P 500 Index - The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

Bloomberg Barclays Aggregate Bond Index - The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).

Past performance is no guarantee of future results. It is not possible to invest directly in an index.

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