Is the 60/40 Portfolio Broken?

Source: U.S. Treasury Department With the current yield curve, an investor purchasing 10, 20, or 30-year bonds will be hard-pressed to outperform inflation. So what does this mean for the traditional 60/40 components? Impact of Low Yields on Portfolio Return Low bonds yields will ask more of the equities portion of the portfolio, which may require riskier positions. Assume we have a standard 60/40 portfolio mix and the target return for the overall portfolio is 8%. If we assume that the 40% position in fixed income will return 2%, what would the remaining 60% in equities have to return to lift the portfolio up to 8%?

Source: Swan Global Investments

The answer may come as a nasty surprise: 12%.

Fixed-Income-and-Forecasted-Returns-60-40-Broken-Swan-Insights

A forecasted return of 2% on bonds might be too generous. Should rates rise, bonds could suffer losses damaging the return of the portfolio.

Rising Rate means Losing Value

The average duration of several Morningstar fixed income categories is listed below. Should rates rise the average fund in these categories would be expected to lose the following amounts.

A forecasted return of 2% on bonds might be too generous. Should rates rise, bonds could suffer losses damaging the return of the portfolio. Rising Rate means Losing Value The average duration of several Morningstar fixed income categories is listed below. Should rates rise the average fund in these categories would be expected to lose the following amounts.

(Numbers are based off of duration information and only take into account changes in interest rates. Convexity is not taken into consideration, nor are other factors such as a widening or tightening of credit spreads.)

In one of Bill Gross’s newsletters from a few years ago, Gross mentions that in order to generate a level of return equal to the 7.5% return bonds have delivered over the past 40 years, yields would need to drop to negative 17%.

In other words, bonds will NOT be delivering return similar to its long-term average over the past four decades.

Unappealing Set of Options

Given these circumstances, investors and advisors are left with an unappealing set of options:

  1. Lowering the return expectation for the overall portfolio.
  2. Increase the equity portion and take on more risk.
  3. Simply hoping that the capital markets will do better than expected and deliver high returns.

Lowering expectations or taking on more risk may not be an option for many investors and hoping that capital markets will do better than expected is a dangerous choice.

If bonds won’t provide the return stream necessary to investors, it may be time to rethink how that 40% of the portfolio is allocated.

Marc Odo is the Director of Investment Solutions at Swan Global Investments, a participant in the ETF Strategist Channel.