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One of the primary sources of allure with the 60/40 portfolio construction is that, historically speaking, stocks and bonds don’t share intimate correlations.
Unfortunately, history didn’t do much for clients in 2022 when stocks and bonds tumbled in unison with aggregate bond funds and the 60/40 structure itself posting one of the worst years on record. Not surprisingly, 2022 woes for 60/40 stirred chatter about its foundation and relevance in a new investing regime. Indeed, 60/40 or slight variations thereof isn’t for everyone. A 40% fixed income allocation is arguably far too high for a 35-year-old client. Likewise, a 60% tilt to stocks could be too aggressive for clients in their 70s.
The good news is that 60/40 is on the mend this year. After all, stocks and broader bond benchmarks are rebounding in healthy fashion. More good news: There’s some belief among market experts that rising 60/40 correlations aren’t as alarming as previously believed.
Good News About 60/40 Correlations
Thanks to the “60”, a 60/40 portfolio is likely performing admirably this year, but there’s legitimate hope for better out of the “40” in the future. In fact, if expectations prove accurate, 60/40 could get its long-term groove back. That groove could be regained even with increased correlations.
“Over the last several months, investors have wondered if 60/40 portfolios (such as 60% S&P 500 Index, 40% Bloomberg U.S. Aggregate Index) should be abandoned because of the rise in correlation between stocks and bonds,” notes Bradely Krom, WisdomTree head of U.S. research.” Based on our research, it appears that it’s actually the starting yield in fixed income that impacts the correlation between stocks and bonds rather than a fundamental shift in market behavior. In a higher yield environment, 60/40 can deliver positive total returns despite correlation remaining positive.”
As noted above, stocks and bonds declined in unison last year, dispelling the notion that fixed income provides a buffer against slack equity markets. That scenario is historically rare because equities and bonds usually aren’t highly correlated, but positive correlations between the two asset classes can work in favor of clients after yields ascend as has been the case for nearly two years now.
History, though not guaranteed to repeat, is meaningful in this instance because bond yields are instructive when it comes to 60/40 correlations.
“In the early 1990s, 60/40 portfolio volatility remained unremarkable relative to history despite persistent positive correlation between stocks and bonds. What gives?,” adds Krom. “In our view, positive correlation appears to be a function of bond yields. During periods with higher yields, fixed income more frequently delivers positive total returns. If rates rose, investors had a larger yield cushion to protect them from negative total returns. If equities also deliver positive returns over the period, correlation is positive.”
Another Positive Point to Consider
Buoyed by this year’s rebound, albeit fairly modest, bonds are regaining their diversification traits, adding to renewed allure for 60/40 portfolios.
That’s a positive point at a time when many experts believe the Federal Reserve will lower interest rates next year, perhaps as soon as the first quarter. However, rate cuts aren’t essential to the 60/40 thesis in 2024.
“Even if the Fed needs to increase interest rates further to tame inflation, the risk of negative total returns for fixed income has decreased markedly now that yields are at the highest levels in almost 20 years,” concludes Krom. “If we contrast this to 2022, when bond yields were still near all-time lows, the pain has been more acute.”
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