Does the 60-40 Portfolio Still Make Sense?
Text on screen: PIMCO
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Text on screen: Jason Odom, Product Strategist, Asset Allocation
Odom: Can you talk about the current yield levels in fixed income and the opportunity that may create?
Text on screen: Emmanuel S. Sharef, Portfolio Manager, Asset Allocation
Sharef: Yes, it certainly has been an extraordinary period of weakness for the bond market with the most rapid rising yields that we’ve seen in decades.
Text on screen: TITLE – YTD returns (%) have been negative across fixed income
Image on screen: A bar graph shows the negative returns year-to-date for five fixed-income classes. Negative returns are illustrated via bars dropping down from a horizontal line at the top of the chart. On the left, a blue bar shows a drop of 9.5%, while another blue bar indicates agency mortgage-backed securities are down 8.31%. In the middle of the chart are two green bars: investment grade credit, down 12.27%, and high yield credit, down 8.04%. On the far right, a red bar shows the drop for emerging markets, down 14.23%.
U.S. treasuries have retraced almost all the way back to their previous peak in 2018, and of course credit spreads have widened along with equities. So it has been very challenging for the aggregate.
Text on screen: TITLE – …but today yields** (%) are at a much stronger starting point; SUBTITLE – Historically starting yields have 94% correlation with prospective returns
Image on screen: A bar graph shows todays yields for five fixed-income classes. Yields are by bars rising up from a horizontal line. On the left, shaded in blue, core has a yield of 3.45%, while agency mortgage-backed securities have a yield of 3.53%. In the middle are two green bars: investment grade credit, at 4.17%, and high yield credit, at 6.46%. On the far right, a red bar shows the drop for emerging markets, at 6.35%.
But the other side of the coin is that now that yields are at these higher levels, bonds represent a much more interesting investment opportunity.
In our analysis in the past, we’ve found that historically, starting bond yields are a really good long run predictor of returns for fixed income, and so the higher yields that we see today are getting really quite attractive, both in absolute terms and then also even compared to equity earnings yields and other asset classes.
Plus, if the economy does slip into recession, these starting yields give bonds a lot more room to rally, so now may be a good time to add selectively.
Odom: Erin, speaking of diversification, the traditional balanced portfolio has come under immense pressure thus far in 2022 as stocks and bonds have sold off simultaneously. Is the 60-40 portfolio dead?
Text on screen: Erin Browne, Portfolio Manager, Asset Allocation
Browne: No, the 60-40 portfolio is not dead. I think measured over a short time horizon, we’ve certainly seen higher inflation negatively impact both stock and bond returns, and certainly we’ve seen that year to date. But for portfolio construction purposes,
Text on screen: TITLE – Rolling 5-year correlation between stocks and bonds
Image on screen: A line graph shows the rolling five-year correlation between stocks and bonds, from January 1967 to January 2022. Correlation is shown on the Y-axis, ranging from positive one to negative one. A horizontal line in the center of the chart represents zero correlation. Since roughly 2002, the five-year rolling correlation between stocks and bonds has been negative, ranging from just below zero to about negative 0.5. From 1967 to 2002, the correlation is positive, ranging between roughly 0.1 and 0.5. In January 2022, the correlation is rising, reaching about negative 0.25, up from its last low of about negative 0.4 in 2020. The correlation in January 2022 is also at its highest point in more than a decade. The chart also shows eight recessions, shaded in gray, over the 55-year time span.
it’s really important to view this over a much longer time horizon, and we don't think that the correlation and diversification benefits of stocks and bonds has meaningfully shifted over the secular horizon.
As you move later cycle, it can be really tricky timing that inflection point, and when you tip over into recession.
So while bonds often underperform during late cycle periods like we’ve seen year to date, they tend to shine very early in the stages of a recession.
Text on screen: TITLE – Performance of stocks and bonds during the first half of recessions
Image on screen: A table shows the performance of stocks and bonds during the first half of eight recessions since December 1969. Bond returns handily outperform those of stocks in seven of the eight recessions, with the exception of the recession that started in March 2001, when bond returns for the first half of the recession were 0.68%, and those of stocks were 4.81%. But typically bond returns greatly exceed those of stocks. In the recession that started in February 2020, bond returns were 4.14% for the first half, compared with a decline of 12.35% for stocks. In the recession that started in December 2007, bond returns were 2.49% in the first half, compared with a loss of 19.29% for stocks. The table also shows how the stock/bond correlation was negative for the last three recessions.
And in fact, if you look at bonds and their performance over the last seven out of the last eight recessions, you've seen that bonds have actually had positive performance in the first half of those recessionary periods.
Given the uncertainty that clouds the outlook coupled with the more attractive valuations for fixed income, we do not think that now is the time to abandon fixed income.
Portfolio construction is going to be key, and we think it’s prudent for investors to expand the number of diversifiers in their portfolios, especially in an environment where the upside risks to inflation have increased.
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