Thoughts on inflation & rates: rethinking the forty
MANNIK S. DHILLON, CFA, CAIA 04-Mar-2021
This time it’s different. Those might be the four most dangerous words in finance. Every time they’re uttered, investors might want to take pause. But given the unusual confluence of events of the past year—the pandemic and subsequent fiscal and monetary responses—it might be appropriate for investors to reconsider the conventional 60/40 portfolio. The next decade is likely to be quite different, and that could have ramifications for investors, particularly with regard to “the forty.”
The 60/40 portfolio (generally seen as a representative balanced portfolio of 60% stocks/40% bonds) has had a very good run. But will this strong performance continue going forward? Nobody knows for certain, but it’s important to remember that there have been long periods whereby this approach has been less effective, including the 1970s and even more recently in the early aughts (2000s). Should investors be concerned?
Perhaps. With interest rates bumping along the bottom, there could be some serious headwinds ahead. As we know, interest rates are hovering around historic lows around the developed world—with some sovereign bonds even sporting negative yields. While the U.S. 10-Year Treasury yield is just over 1.0% as of early-February 2021, it is really not that far from the zero bound, which dampens future return potential.
From a risk-reward perspective, such low rates pose risks to bond prices should they rise versus the gain potential in the event rates go even lower. Several decades of declining rates have provided a tailwind for bond prices, but that driver of total returns seems unavailable in the coming decade.
Moreover, the confluence of current economic, fiscal and monetary policy factors appears poised to push rates higher over the longer-term. But don’t just take my word for it. Various Federal Reserve presidents have been out jawboning for higher inflation, stating explicitly the willingness to exceed the long-standing in 2% inflation target. Of course, rising inflation expectations generally coincide with rising interest rates. As a result, investors may want to rethink their existing bond allocation, especially longer duration or maturity investments.
So, what does that mean for investors and the popular 60/40 balanced portfolios? Here are three considerations for investors:
1. Often categorized as Liquid Alternatives, there are nuanced investment funds that aim to provide an alternative source of income, while also maintaining a low correlation to bonds and stocks. Although the specifics of these types of strategies vary widely, they might be an appropriate supplement to a traditional bond allocation. However, from an asset allocation and portfolio construction standpoint it’s important to seek out those that have similar risk profiles to the asset class you are replacing (fixed income in this case).
2. Fixed income strategies investing in floating rate bonds are built to have low duration, which is a measure of sensitivity to interest rates. Thus, these strategies may be able to provide potential income, and they should be less impacted by unexpected changes in interest rates.
3. Finally, remember that popular bond benchmarks (such as the Bloomberg Barclays U.S. Aggregate Bond Index, known as the “Agg”) have significant weighting to Treasuries and other sectors considered highly sensitive to interest rates. In contrast, some actively managed portfolios can focus on an expanded opportunity set and may provide income potential with a better risk-reward trade-off in a rising rate environment. A slightly higher-than-normal allocation to investment grade corporates, which offer a yield premium to Treasuries, are a worthy consideration.