Joseph Cerqua, CFA | EIP Investment Research
For decades, the classic balanced portfolio has been a winner for investors. It captured solid positive returns in equities but with less risk than a pure stock portfolio. This provided a profitable yet stable vehicle for those with moderate risk tolerance. The benefits were derived from two key factors. First, the negative correlation of bonds to stocks meant that declines in stock prices were typically offset by gains in bonds during times of stress. Additionally, bonds generate a fixed level of income. This is particularly valuable to retirees who require investment income to help cover living expenses after they exit the workforce.
The combination of safety and income naturally becomes more attractive with age. The entire $2 trillion Target Date Fund business is basically a balanced portfolio model that shifts more money into bonds over time. The disclosures warn us that past performance is no guarantee of future returns. In this case, that should serve as more than just a footnote. Today’s era of near-zero interest rates has fundamentally changed the components of return and will make it difficult for the traditional balanced portfolio to deliver as it has in the past.
The “Death of the 60/40 model” has been a popular topic lately. The time has come to move on from discussion and start providing solutions.
LACK OF INTEREST
Do you remember the last time that you checked the interest rate on your bank account? It has probably been a while. That is because you know the answer is basically zero. The secular decline in interest rates has been taking place for nearly forty years. The response to Covid-19 pushed rates to unprecedented levels. The chart1 below shows the average annual yield on US Treasuries since 1990. In 2020, that rate dropped below 1%.
While this helps stabilize the economy, it has punished savers and those who need income from their investments. As of November 30, 2020, the yield on the Barclays Aggregate Bond ETF was just 1.09%.
So why is this important?
COMPONENTS OF BOND RETURNS
The current yield on a broad bond market index is a pretty safe return on your principal over the next twelve months. But as we stated that offers a paltry 1.09%. The other source of return in a bond portfolio is its price change. As a refresher, the price of bonds moves inversely with the direction of interest rates. So as rates fall, bond prices rise and vice versa2. This is due to the change in value that prevailing bonds experience when rates change. For example, if your bonds pay an interest rate of 5% and falling rates cause new bonds to come to market paying just 3%, yours would become more valuable.
Given the long downward trend in rates, bond returns have been boosted by additional price appreciation for years. In fact, the majority of returns over the last two years has been driven by falling rates. Through November 30, 2020, this year’s total returns for the Barclays Aggregate Bond ETF were derived as follows:
Income yield: 1.99%
Change in Price: 5.30%
Total Return: 7.29%
By all accounts, that is a period of solid performance but it begs a question. With yields just over 1% today and little room for rates to move lower, where will the sources of bond returns come from in the future?
HOLES IN THE SAFETY NET
Downside protection has been a key benefit of allocating a portion of your portfolio to bonds. When the crisis hit, rates tended to fall and drive bond prices higher. Put simply, while one chunk of your portfolio was falling, the other was rising. This mix helped deliver a smoother ride for investors. However, we now see bonds as less capable of providing that hedge. The cushion from interest income is now negligible and there is limited upside to prices as rates have little room to fall further.
The chart3 below reflects what could be a new paradigm. Historically, balanced portfolios kept losses in the single digits. In recent bear markets, double-digit losses have become more common. In fact, balanced portfolios lost well over 20% in two of the last five bear market events. The smooth ride may have reached the end of the road.
Finally, we must also consider more normal periods. The see-saw dynamic pictured earlier can also work against bonds. Given the current rate sensitivity of the index, a 1% move higher in rates would drive bond prices about 6% lower. With just 1% of interest income to go along with that, a scenario in which rates simply normalize would now drive negative returns from bonds.
A BETTER BALANCE
The tried and true method of lifecycle investing says that we should rotate more money into the safety and income of bonds as we age. This has been a safe bet which means few advisors are willing to suggest anything different today. But its success is built upon a foundation that has significantly deteriorated and is unlikely to deliver the same risk and return profile going forward. So, what should investors do? Accept an investment vehicle that no longer meets their needs or accept the higher risk of stocks at a stage when they have more to lose and less time to recoup losses? It is not much of a choice.
This dynamic will be confronting a growing number of investors as the baby boomer generation continues to age. Yet as widespread of an issue as this seems to be, we have seen very few solutions provided by the investment industry. This is likely since it will require customized portfolios that may be more difficult to explain and are certainly less scalable. In other words, they don’t sell as well. But they do exist. We have set out to fill the void that the industry has left behind.
There is a variety of alternative asset classes capable of producing income levels comparable to what bonds used to provide. Preferred stock, real estate, limited partnerships, high yield bonds are just a few examples. However, these investments typically carry more risk than investment-grade bonds. So, while their yield is attractive, we must address the need for safety as well. With limited ability for bond prices to offset falling stocks, we see direct short positions against the stock market as the most reliable way to protect against severe losses.
The combination of high-income generating securities along with positions that rise as stocks fall provides a unique solution. We have constructed such a portfolio based on that strategy. One that targets twice the yield of investment-grade bonds and half the risk of stocks. Key details are as follows:
EIP HIGH INCOME STRATEGY
As of 11/30/2020:
Portfolio Yield: 5.72%
Barclays Aggregate Bond Yield: 1.09%
The investment industry has exploded with products that offer canned portfolios to the masses. However, the opportunity set is constantly changing. Successful investments of the past get piled into at more expensive levels and drive the value out of once attractive propositions. We believe the new era of ultra-low interest rates has done that to the traditional balanced portfolio. The deck is now stacked against what has worked and the time has come for investors to find a better balance.
1. Historical yield data from Macro Trends
2. Rates vs. Prices Graphic from PIMCO
3. Balanced Portfolio Returns calculated by Kwanti Analytics based on 60/40 mix of S&P 500 and Barclays Aggregate Bond ETFs.