60/40 At Record Low Yield

We recently reviewed an interesting analysis of the history of the yield on a 60/40 portfolio going back to 1878. This portfolio is allocated 60% to stocks (equities) represented by the S&P500, and 40% to fixed income (bonds) represented by the 10-year U.S. Treasury bond. “Yield” is a measure in percentage terms of the cash flow generated by the portfolio (from interest and dividend payments) relative to total portfolio assets. It is not the same as total portfolio return, which includes both yield as well as capital appreciation (or loss). A 60% equity, 40% fixed income portfolio has been long-used as a “benchmark” or default allocation for retirement investing.

Here is what is interesting: the median yield on this portfolio going back 134 years is 4.2%. On August 31 of this year, the yield on this portfolio reached a record low of 1.98%. The last peak yield in this portfolio was in 1983 at about 9.8% (interestingly about the same level as the peak in 1932).

Why is this so fascinating?  Because 1) it offers an important historical perspective, and also 2) because it has several important implications for investing looking forward, which include:

§  Bond yields, now at record lows, offer very poor return option currently. They may still be required as a means of preserving capital but at a high opportunity cost.

§  Because bond prices move inversely to interest rates, current low bond yields combined with  declining bond prices when rates go up could result in the forward returns on a passively managed 60/40 portfolio below that of the past ten-years’ actual annualized return of 6.9%.

§  In order to achieve higher portfolio returns, investors may have to incur (and tolerate) higher  risk by increasing their holdings of equities and embracing greater flexibility in asset allocation.

Expected portfolio return is an important element in financial planning.  It has an important bearing on the outcome and probability that one will have enough capital to fund their retirement through life end. The current historic low bond yields are a conundrum. Several ways in which we can work to offset the lower bond returns is through utilization of higher yielding bond “surrogates” such as utility stocks or preferred stocks. There are also options for investing in higher yielding foreign bonds, particularly those of stronger emerging market economies. Also, conservative higher yielding equities, such as telecommunications or certain energy stocks, can also offer yields that can help to improve forward portfolio returns without incurring significantly increased risk. Holding higher-yielding equities can also offer some hedge against inflation as companies can raise dividends on stocks, but cannot raise the interest payment on a bond.