With Bond Yields < 1% . . . Does Your Portfolio Need a Remodel?

With Bond Yields < 1% . . . Does Your Portfolio Need a Remodel?

The yield on 10-year U.S. Treasury Notes recently reached historic lows, as did the yields of bonds, both domestic and international. Forecasts indicate they will remain low .Just like home interiors that become outdated with the times, so do investment portfolios. Investors who seek higher yields, without the corresponding risk and correlation of the stock market, may want to consider alternative investments to remodel their portfolio in 2021.  

10 Year Treasury Note Yield - from 1965 to 2020

Source: Powered by YCHARTS, January 2020

In the wake of various governmental quantitative easing programs and intervention by the world’s central banks, fixed income returns have declined, in some cases to negative yields. Top economists posit that these low yields are here to stay. Their consensus is that bond yields, which traditionally returned greater than 3.5% yields over the past decade, are now expected to return only about 1% for the next ten years. 

Bond Next 10-Year Yield Forecast

Sources:  BlackRock, 2021 Capital Market Assumptions, JP Morgan, 2021 Capital Market Forecast, Vanguard, 2021 Economic and Market Outlook

If these forecasts ring true, investors may not only end up with lower bond yields than they’ve been accustomed but also less overall portfolio returns (equity and fixed income combined). Moreover, if the economists’ consensus is wrong and if yields rise in the short term then investors will risk losses prior to their bond’s maturity, also having an adverse impact on the total portfolio. 

Should you dump your bonds?

With the depressed future of bond yields, one might ask “Why don’t I just sell all my bonds and position my portfolio 100% into equities?”.  Probably not! A reallocation to all equities means a lot more risk and volatility. The reality is that stocks are increasingly viewed becoming “over-valued”. Nobel prize winner, Peter Schiller, created the Schiller PE ratio to measure the overall stock market’s price to their earnings (PE) ratio over time. Schiller’s index has successfully predicted major market corrections over time. The index currently indicates that equities are valued at all time high levels.

Schiller PE Ratio (through to 2020)

Source: Multipl

If not stocks, then what? 

Before considering any new class of investments, investors should be reminded of the original purpose for their bond allocations. Bonds have been an important part of a portfolio for the volatility suppression that they provide. Investors have long appreciated the shock absorption that bonds provide for their entire portfolio during a correction or market downturn. Therefore, jettisoning all of them is most likely a bad idea.  

The most prudent action may be to keep the same allocation percentage of bonds but simply to change the mix of bonds types (within the fixed income mix) in order to pursue slightly higher yields without much additional risk. This could be accomplished by diversifying into:

• Shorter duration bonds 
• High-yield corporate bonds
• International & emerging market bonds
• Mortgage backed securities
• Inflation protected bonds 
  

Such a diversification within a fixed income allocation may be the only action needed for most investors.

What other options are there?

BlackRock, the world’s largest asset manager, recently updated their capital market assumptions and incorporated them into the traditional risk/reward trade-off framework. They’ve plotted the estimated risk in contrast to the expected returns for the next ten years.  

BlackRock 10-Year Capital Market Assumptions; Risk/Reward Trade-offs

Source: BlackRock, January 2021, Winter 2021 briefing webcast

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They along with other global asset managers recommend the use of alternatives for more risk tolerant investors. These alternative investments can include:

• Real estate investment trusts (REITs) 
• Private placement real estate (limited partnership)
• Preferred equity 
• Private debt & private equity  
• Venture capital & hedge funds   
• Commodities and/or precious metals (e.g. Gold) 
  

Several of the above options are not liquid (they are available on publicly traded exchanges) and may require that an investor reach the threshold to qualify and register as an Accredited Investor.

Does my portfolio need a HGTV like remodeling?

There is no one-model-fits-all reallocation for everyone. A multitude of factors including the number of years until retirement and personal preferences determine the ideal allocation for any given investor.  Nonetheless, for illustration purposes below is the most common portfolio among investors; the 60/40 allocation (60% stocks and a 40% bonds) and how it could be remodeled for a risk tolerant investor:

Sample 60/40 Portfolio Reallocation with alternative investments added

 Source: Farther Finance

Now what?

The first step in determining how to change any portfolio allocation and the investments within each class is to understand the current risk/reward profile within it. Frequently the risk being taken in a current portfolio is not well understood, even if the returns have been quite satisfactory. One needs only to look at how a portfolio behaved in a time of stress (e.g. the Covid pandemic months of February through March of 2020) to realize that underlying risks taken in many portfolios were not well understood. 

The second step is to determine what additional risk and therefore expected return is worth targeting. Ultimately, the goal is to find the balanced mix of assets that for any given level of risk that provides the highest expected return (as illustrated in the BlackRock framework above).

While Alternative Investments typically represent more risk than fixed income investments, they can be carefully selected to avoid the risk level of the global stock markets. Alternatives can be handpicked or combined in a way to offer low, or even negative correlation, to the U.S. equity market. This is important in order to replace the historical cushioning that fixed income (bonds) provide an investment portfolio. 

Yet, even if investors seek to re-model in 2021, they would be wise to do so on an account-by-account basis.  For example, a qualified account (otherwise known as a tax deferred IRA/401K/retirement account) may likely have a different allocation strategy than an investment account (an after-tax dollars invested account).  Furthermore, a short-term goal-oriented savings account (where principal preservation is important) may have a much more conservative profile than any other account. In any portfolio remodeling project, re-allocation strategies need consider the projected term and overall goal for each account.