Is the 60/40 Portfolio Dead, Yet Again?

On this episode of The Long View, Charles Schwab’s chief fixed-income strategist Kathy Jones discusses the recession outlook, interest rates, bonds, and more.

Here are a few excerpts from Jones’ conversation with Morningstar’s Christine Benz and Jeff Ptak.

On 60/40 Portfolios Being Dead

Benz: We’ve seen a lot of chatter about whether the 60/40 portfolio is dead, and this seems to assume that bonds won’t be the reliable diversifiers they’ve been in the past. They weren’t reliable diversifiers last year for sure. Is there any economic basis to that assumption that the 60/40 portfolio or some sort of balanced portfolio just really won’t deliver in the future?

Jones: No, I don’t think so. Generally, when people say that they’re really worried about the 40, not the 60. They’re worried because last year bonds didn’t provide diversification from stocks. They both went down together. But I think the environment we’re in right now is completely different than last year, and I think last year was unique to the starting point. We had many years of zero/negative interest rates around the world, very, very low yields, and then a very, very rapid increase in those rates. So, naturally there weren’t a lot of places to hide in the bond market. And at the same time the stock market was reacting to that rapid rate of rate hikes and the sudden shift in Fed policy.

Now we’re starting from a very different place where bond yields are higher, and that provides a cushion against volatility because you’re getting a higher stream of income, regular payments. And typically, what you get out of a bond isn’t the price change so much as the income stream. And now we have very attractive yields that are available, and I think that from that starting point, we are back to a place where 60/40 can make sense again. From an economic point of view, bonds still are going to provide that capital preservation, that certainty of the timing of when you get your principal and interest payments, and I think that offsets risk to your asset classes now that the nominal and real interest rates are actually moving back toward a more normal level.

Will Bonds Return to Normal?

Ptak: We know that bonds were down big last year, but now that yields have risen, it seems they would afford some protection. Does history bear that out? Have we seen that bonds have not suffered long routs because their higher income payouts offset further damage from rising rates? And I suppose that we probably should qualify nominal versus real, but let’s focus on nominal for the moment. Have we found that bonds do tend to protect themselves after an episode like we went through last year?

Jones: Actually, history tells you that it’s pretty rare to have a negative total return on a high-quality bond portfolio. No matter what the environment we’re in, because it’s that income stream that delivers most of what you get in the bond. When we look back over history, there’s a handful of years when the total return, that is the income plus or minus the price change, has been negative, and that’s because of the income stream. And even in rising-interest-rate environments—all of the ‘70s and ‘80s when yields were rising—the total return was rising because the income generated was offsetting the price decline. It really is an anomaly to have bonds do so poorly, and I think it was a unique set of circumstances. I think going forward, they’ll return to the stable income-generator that they have been in the past.

Bond Funds vs. Individual Bonds? What’s Best for Individual Investors?

Benz: You mentioned just a minute ago, Kathy, that bonds are attractive to investors because they can help them meet their spending needs. They can match the bond to their spending needs. I’m hearing a lot of enthusiasm from investors about individual bonds versus bond funds, largely because of the experience that bond-fund-holders went through last year. Do you think that it’s a good idea for individual investors to be out there trying to build diversified portfolios of individual bonds? How would you suggest that people approach that?

Jones: I’m agnostic as to the way people invest in bonds, because I think there are a lot of different ways that can work for different individuals. The advantage, as you mentioned, to individual bonds is you have your own cost basis. You have that certainty of when you’re going to get your principal back and your interest payments, and we do tend to find that investors who hold individual bonds ride out the ups and downs of the market better than people who might be in funds, because the fundholders look at the net asset value going down and get very nervous and sell. And oftentimes they’re selling at the wrong time, because they don’t have the certainty of what they’re going to get down the road in the future.

The disadvantage of building a portfolio with individual bonds is you need a fair amount of capital to make sure you get enough diversification in a bond portfolio of individual bonds, so that can be difficult if you’re a smaller investor. The second issue is you have to do your own work in terms of the credit work to make sure you’re selecting bonds that aren’t running into difficulties, have some risk of default, and you have to pay attention if they’re callable. There’s a number of issues when you look at individual bonds, it’s a little bit more complicated than just buying, say, a stock of a company that you know. That company might have one stock out there, but it might have 10 different types of bonds. It involves some work on the individual’s part to manage that portfolio.

And for a lot of people, that’s just a lot of work and maybe beyond what their capabilities are or their interest in learning is. Having a mutual fund or some ETFs can make sense, and certainly some combination of the two can make sense as well. We have a number of investors who will build us a pretty straightforward bond ladder for the core holdings. But then maybe add some mutual funds or some ETFs around that so that they have access say to other parts of the market where they’re not comfortable investing at a reasonable cost and getting that active management or that professional management at least in their portfolios.