“The 60/40 portfolio is dead!”
How many times have you heard this? This statement has been repeated so often, that many investors have taken it as truth without understanding the fundamental principles involved. But repetition doesn’t make it so.
I understand the sentiment. On the surface, investing in bonds has been a dismal proposition. When interest rates were low, bonds offered little appeal. Back in November of 2020, I wrote, “bond prices are too high to be safe and yields are too low to provide income.” Bonds were simply not fulfilling their traditional role in investment portfolios. These were the yields on Canadian government bonds around that time.
As yields went down, prices went up. If you were a bond holder you might have felt very reassured when popular bond ETFs like ZAG had returns like this:
Leading up to mid-2020, bonds had been going bananas. But since then investors have been punished with one of the biggest and baddest bond routs of all time. Just look at how ZAG, one of Canada’s largest bond ETFs, has performed since 2020. The “safe” portion of millions of investors’ portfolios dropped a whopping 24.6% from August of 2020 to October 2023.
If you didn’t think the 60/40 portfolio was dead before, surely now we can all agree that bonds should be thrown out with VHS tapes and leaded gasoline – things that seemed reasonable in the 80’s but turned out to be useless junk.
Not so fast. For the first time in years, bonds are finally back in my portfolio. Yes, bonds are back. Understanding why requires a quick review of how bonds work.
How do bonds work?
We’re going to limit our discussion to investment-grade bonds – the only kind I would consider investing in.
Bonds are contracts in which one party loans money to another. The contract has a term, i.e. a maturity date when the principal (face value) will be returned to the lender, and a coupon rate, i.e. the interest that the bond pays annually to the lender (divided semi-annually for Bank of Canada bonds).
You could buy a bond and hold it until maturity, but a bondholder doesn’t have to do that. They can sell it on what is called the secondary market. And this is where things get interesting.
Why bond prices and yields move in opposite directions
Imagine James bought a $1000 10-year bond with a 3% coupon (interest rate). One year later interest rates have gone up and new 10-year bonds pay a 4% coupon. If James wants to sell his bond, a potential buyer would need to be compensated for the fact that James’ bond has a lower coupon than current rates by paying a lower price. In this case, James’ bond would only be worth $925. The new “yield” of the bond, 4%, is a combination of the original coupon and the discounted price.
This is why bond prices fall when interest rates rise, and vice versa. When interest rates were at rock bottom in 2020, bond prices were so precariously high that they really only had one way to go – down.
Some bonds are more sensitive to interest rate changes than others. This sensitivity is measured by something called “duration” (not to be confused with maturity). The higher the duration, the more sensitive a bond’s price is to interest rate changes. If a bond has a duration of 8, then a 1% rise in interest rates will tend to lower the price of the bond by about 8% and a 1% drop in interest rates will cause an 8% rise in the bond’s value. Bonds with lower coupons and longer maturities tend to have higher durations – i.e. they are more sensitive to interest rate changes.
The role of bonds in a portfolio
Historically, government bonds have returned about 2% more than the rate of inflation vs. about 5% for stocks. But growth wasn’t the primary role of bonds in investment portfolios – that’s the job of equities.
Traditionally, bonds had three main roles in a portfolio:
- Steady income
- Lower overall volatility
- Improved portfolio risk-adjusted returns due to being relatively uncorrelated to stocks
When interest rates were low, not only were bonds not providing significant income for investors, but they were also more risky. Even if the volatility of bond prices remained low for a long time, which it did . . . until it didn’t, many investors learned the hard way that there was far more downside risk than they realized.
Sure enough, when interest rates rose, bond prices were decimated. We’re used to seeing 20%+ corrections in stocks but a 20%+ crash in bonds . . . that is truly unsettling. What is even more unusual is to see stocks and bonds crashing at the same time. Holders of traditional 60/40 portfolios were crushed in 2022 like they’ve never been crushed before.
Does that mean bonds are a bad investment going forward? Absolutely not. Those are sunk costs. Investing is about the future.
What about now?
When the stock market dips by 20%, do we abandon stocks? No. We know that we should just keep buying, taking advantage of lower prices.
When it comes to stocks, it’s all about future earnings. When it comes to bonds, it’s all about yield. Current yield is the best indicator of future bond returns. Bonds are looking pretty good to me at current yields:
Even if rates stay the same, you’ll get those nice interest payments. And if rates go back down – due a recession, for example, you’ll benefit from higher bond prices. The bottom line is that expected future returns for bonds are better than they have been for 15 years.
Reasons to consider bonds in your portfolio
Perhaps, like me, you have been underweighting or even eliminating bonds from your portfolio for years. Now may be a good time to consider the merits of a more traditional portfolio that includes bonds.
Here are the reasons I think bonds are worth considering:
- Bonds are producing income again. Even if rates stay where they are, investors will enjoy positive returns from interest income
- If interest rates go back down, there is upside potential on bond prices
- Higher interest rates means lower duration and, therefore lower overall volatility
- Bonds have higher expected future returns than they have in a long time
Where do dividend-paying stocks fit in?
Until recently, investors had few good options for safe, income-producing assets. Increasing your allocation to large, blue-ship dividend-paying stocks was likely one of your best options. This is what I did, with a particular focus on big, boring utility companies with low betas. I got stung doing that, along with many other investors.
Dividend-paying stocks – and BTSX stocks, in particular – still play a large and important role in my portfolio but I am much more comfortable finally having some diversification into an asset class other than equities.
Personally, I have moved about 10% of our portfolio into bonds using a simple, low-cost Canadian bond ETF (I don’t recommend junk bonds, speculative bond trading, or buying individual bonds). At nearly 50 years old, there’s a good chance I’ll add to that allocation over time.
If there is a fire sale on stocks, I’ll be happy to have these funds to mobilize and, in the meantime, I will enjoy a steady stream of interest income along with improved risk-adjusted returns for our portfolio as a whole.
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