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Advisors that have been in the business awhile, say a couple of decades or more, know that the 60% equity/40% fixed income split is something of an industry standard.
“Gold standard” is probably up for debate. Sure, 60/40 delivered double-digit returns in 2020, but that was just the seventh time that happened over the past two decades. Much of the old guard thinking with the 60/40 construction boils down to the following factors: Having enough equity exposure so that client portfolios benefit during strong trending bull markets and having enough bond allocations to generate income and buffer against equity downturns.
As the early stages of 2021 are showing advisors and clients, not all safe haven assets are safe all the time. That's clearly true of U.S. government debt today.
As Matthew Bartolini, head of SPDR Americas Research, points out, just two fixed income segments generated positive returns last month: Junk bonds and senior loans. Either way, investors had to take on additional credit risk to see some upside with bonds, underscoring some of the current woes facing standard 60/40 portfolios.
Ominous Outlook for 60/40
Worsening the forecast for 60/40 portfolios is that 10-year Treasury yields, even after more than doubling in six months, are still low. The yield was 1.596% at the March 8 close, indicating there's plenty of room to the upside. That could also portend more steepening of the yield curve.
“The yield curve (difference between the US 10-year and US 2-year yield) steepened last month to its widest level since 2018, surging to 128 from 96 basis points at the start of the month,” says Bartolini. “This is all from movements in the US 10-year, as it rose by 34 basis points.”
On the surface, rising rates can be positive for generating income – if portfolios are properly allocated. Take bow if you overweighted client portfolios to junk bonds and bank loans last month.
Unfortunately, it's unlikely that many investors were adequately exposed to those corners of the bond market in February. Chances are they were allocated to the Bloomberg Barclays US Aggregate Bond Index or some comparable gauge, meaning “core bond” exposure. Problem is the Bloomberg Barclays US Aggregate Bond Index, with its piddly 30-day SEC yield of 1.28%, devotes 37.57% of its weight to Treasuries.
That's one issue. The others indicating 10-year yields have further to climb are the Federal Reserve's easy money stance and a country soon to be awash in fiscal stimulus – again. Remember, that stimulus is fund by Treasuries, creating upward pressure on yields.
“The Fed is unlikely to change its accommodative monetary policies aimed at reflating the economy, considering unemployment is still over 6%,” adds Bartolini. “If you consider the more comprehensive U-6 measure of unemployment that includes marginally attached workers as well as those working part time, that figure is over 11%, well above where it was a year ago.”
Palatable Solutions
Advisors do have some avenues for dealing with the rising rate quagmire. An obvious one is to simply dial back fixed income allocations and divert some of that capital to equities. Financial services stocks – thank you rising rates – beckon as does small-cap value.
On the income side, variable rate preferreds are worth mulling do to the floating rate component. On that note, there is something to the steadiness of senior loans seen in February. Although credit risk is part of that equation, the asset class usually isn't significantly more volatile when rates rise while offering other perks.
“As loans have a floating rate component to them, a rise in rates may not have as much of an adverse impact on total return as it could on fixed rate high yield– evidenced by curve change effects subtracting 142 basis points of return in 2021 for fixed rate high yield versus a negligible impact on loans,” notes Bartolini.
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