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SUMMARY
- Bond yields have risen dramatically…
- Improving the risk/reward prospects for traditional balanced portfolios.
While we and investors around the world worry about inflation, war, and elections, we continue to believe in the benefits of diversification and cannot help noticing that the long-term risk/return prospects for a balanced portfolio look better to us than they have in a long time. This is in part due to the significant rise in interest rates, and the fact that the 10-year Treasuries yields are above 4.5% for the first time since 2007. Importantly, we believe the starting yield of a bond is the key determinant of a bond’s return over time.
Diversified (or balanced) portfolios, broadly speaking, generate returns from two main asset classes: Equity and Fixed Income. Equity investments generate portfolio performance via the rise (or fall) in the investment’s price and any dividends that the investment pays. Fixed Income investments generate return for the portfolio via their yields. In an environment where bond yields have risen dramatically, there is less performance required from the equity portion of a diversified portfolio.
To demonstrate how a diversified portfolio performs, let’s look at a mathematical example using current data. If an investor is seeking an annual portfolio return from a diversified portfolio and is willing to accept some additional risk (above that of a Treasury Bond), the Bloomberg US Aggregate Bond Index, which includes corporate and mortgage bonds, is now yielding around 5.4%. Because this yield is higher than in previous years, the returns required from stocks to meet one’s goals in this example are significantly lower than in previous years. This is especially true for the period between mid-2011 and mid-2022 when 10-year Treasury Note yields remained largely below 3%. When rates are extremely low, stocks must deliver much higher returns to carry a balanced portfolio. The math is simple on a sample portfolio made up of 50% bonds and 50% stocks. For example, if one has a 6% return objective and bonds can return 5%, then stocks only need to return 7% over time (see Table, below) to meet that objective. The table below further illustrates different scenarios of what equity return would be required given varying starting bond yields, in order to meet a stated portfolio objective. This is only intended as an illustration and is not a reflection of any RiverFront portfolio. Current yields are quoted as an example and are subject to change. All investments carry a risk of loss and there is no guarantee that a portfolio will reach its investment objectives. Importantly, diversification does not guarantee a profit or protect against a loss. You cannot invest directly in an index.
If we look at this in the context of today’s market environment, a lower return expectation for stocks is probably appropriate given their higher valuations and the higher interest rate environment, which may draw money away from stocks. Additionally, while we do not agree with the many Wall Street outlooks, should they prove more correct in the short term, we see today’s higher bond yields helping to offset lower equity returns in a diversified portfolio.
In a world where investors may be tempted to favor cash equivalents, like T-bills, CDs and money market funds, over more traditional investments it is important to consider two points. First, short-term investments are, by definition, short-term; meaning they mature in less than one year and often much sooner. At maturity the proceeds will need to be reinvested into an unknown market environment. This makes these types of investments sensitive to the many pitfalls of market timing. One could get lucky, and yields could remain high… or unlucky, if yields are lower and stocks are higher. Second, due to their short duration, cash equivalents are unlikely to provide the diversification benefits of a bond portfolio. This is because the prices of cash equivalents cannot be expected to significantly rise when interest rates decline, like rates often do during stock market selloffs. (For more on the risks inherent in short-term investments see: Weekly View from 8/21/23, Castles in the Sand)
We are hearing throughout our travels that many long-term investors are deferring the purchase of stocks and bonds. We think this is ironic given our view about the potential returns of stocks and bonds. Furthermore, while past performance is no guarantee of future results, we cannot help seeing the similarity between investor behavior today to the late 1970’s and early 1980’s, when bond yields were in the double digits. Back then many failed to ’lock in’ those high Treasury bond yields for ten or more years because they were attracted to the comparably high yields offered by short-term investments. What they failed to consider was that the returns on cash equivalents were fleeting when compared to the subsequent returns on bonds.
Conclusion
Today, one cannot be certain whether stocks have bottomed out or interest rates have peaked. However, despite this uncertainty, we continue to believe in the power of a diversified portfolio and are optimistic about the risk/return profile of a well-constructed balanced portfolio. This can be credited to the three full percentage point increase in bond yields and because the valuation of global stocks are reasonable, in our view.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.