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One last hurrah for the 60/40 portfolio?

Markets move in cycles. The last 40 years have seen interest rates down from 20% to less than 1%, quietly fuelling a rise in bond returns over the same time. This has driven the return of the typical 60/40 portfolio (60% stocks and 40% government bonds).

Over the 40 years, the benefit of the 60/40 portfolio has been that when economic growth has slowed:

  • stock prices have been weak
  • but interest rates have fallen, increasing the return on bonds

And vice versa for when economic growth has improved.

With interest rates at almost zero, there is a reasonable argument that this trade is over for the current cycle. I'm quite partial to that argument for Europe and Japan.

But for Australia, I'm expecting one last hurrah before the end of the cycle.

A bond Armageddon?

Government (as opposed to corporate) bonds are typically a low-risk investment. However, there are plenty of doomsayers for the government bond market calling for a bond Armageddon with 10-year bonds losing 35% with a return to ‘normal’ interest rates.

And the doomsayers are (technically) correct that if 10-year government bonds rose from the current level of below 1% to a more typical 6% then the ten-year bond price would fall 35%. But this is grossly misleading as to the true risk to investors (rather than traders) for four reasons:

Reason 1: The speed of adjustment is key

The -35% price movement in 10-year bond prices is only true if it happens overnight.

A bond ladder is a more typical exposure for investors. Those who invest directly or (like our clients) through a separately managed account have far less to fear.

An example bond ladder might have one bond expiring every year for the next 15 years. Each year, your bonds move one year closer to maturing. Each year you take the money from the bond that matures and buy another 15-year bond.

If bond yields move evenly from current levels to 6% over 10 years, then bond investors with this strategy will make a profit. Not a great profit admittedly, only about 0.5% p.a. – but a long way away from a 35% loss.

If the increase in interest rates was faster, say five years, then you would make a loss (if you sold the entire portfolio in five years) of about 2.5% p.a. Not a good outcome. But not a shocking risk.

Reason 2: 10-year bonds are a trading strategy, not an investment

Ten-year bonds are not really an investment. You can buy a 10-year bond, but in one year you no longer own a 10-year bond: you own a nine-year bond.

To keep a 10-year bond, you need to sell your 9.75-year bond and buy a 10.25-year bond, then wait six months and do the same thing again. And again. And again. 17 more times.

This is the action of a trader, not an investor.

The effect on investors, who tend to have a range of different maturities, especially in a 60/40 portfolio is significantly different from a trader.

Reason 3: Traders take risks on bonds, investors get certainty

Traders who buy and sell rapidly, or who use leverage, or who take long/short positions have reasons to worry about significant losses on bonds.

Typical investors, though, buy bonds because of the certainty they provide.

When you buy a current Australian 10-year bond, you know exactly the return you will get if you hold it to maturity. You will pay $115 today for the bond, you will get $1.25 every six months, and in May 2030 you will get back your $100. You have locked this return in.

The price of your bond will vary. But for an investor who is holding to maturity, the returns do not change.

Reason 4: Inflation

Most bond doomsayers that are calling for the Armageddon are doing so because they are forecasting the imminent return of inflation.

One day they will be right. But the developed world has spent the last ten years (20 years in Japan), trying to create inflation. And failed.

Now the world is staring down the largest unemployment shock since the great depression. Household and corporate debt levels are already elevated - it will be difficult and increasingly dangerous to increase them from current levels.

Inflation is the most significant risk facing any bond holding. But it is not a risk right now.

My view is that a mix of increasing inequality and central bank rules make it very difficult for monetary policy to create inflation. Inflation, when it finally comes will be a reversal of inequality and massive stimulatory government spending. The government spending we are seeing at the moment is to reduce the depths of the recession, it is not (yet) the type of spending that increases inflation.

What is the last hurrah?

The real benefit of bonds is that you know already how much money you are going to lose over 10 years if you hold to maturity. The answer is zero. If you buy a 10-year bond at 0.9% and hold it to maturity, you will get 0.9%.

That is the point. Bonds give you certainty of return. What they also give you is the option to sell the bond part of the way through to take advantage if yields continue to fall.

At the moment, Australian bonds are among the highest in the developed world where credit risks are low:

If Australian bond yields chase the rest of world bond yields lower, and we expect they will, the value of a typical bond ladder will increase 5-10%. As I've noted above, that only matters if you sell the bonds though.

In our portfolios, we do expect to sell these bonds and switch into equities at some stage.

Going forward, the risk-return equation for bonds is broadly:

  • 5-10% p.a. upside if we are right and economic conditions worsen.
  • 5% p.a. losses if we are dramatically wrong.

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What about a ‘set and forget’ 60/40 portfolio?

Here is the difficult part. If you are buying and holding, then your bonds are not going to give you much of a return. Plus, stock markets are trading at valuation levels that are as expensive as they have ever been.

I don't mind the outlook for the world economy once we get deeper into the 2020s - but more on that another day.

It is possible that markets will continue to hope for better profits for several years until the profits finally justify today's prices. Basically, a sideways move for years.

Based on current valuations, buy and hold is unlikely to be a winning strategy. Within our superannuation and investment funds, we are expecting to need to be considerably more nimble than a set and forget 60/40 portfolio to achieve reasonable returns.


Damien Klassen is Head of Investments at Nucleus Wealth. This article is general information and does not consider the circumstances of any investor.


David I
October 11, 2020

The elephant in the room is currency debasement/debt all over the world. This makes me think that precious metals and hard assets are the investment of our time. With a few more trillion, at least, coming in the US in the near future, the USD will drop, gold is in a bull market. I like Aussie gold producers in my SMSF and when I sell will buy listed real estate like industrial, childcare, data storage, local neighbourhood etc for income.....maybe a tipple on other commodities. Everything else is too hard.

October 09, 2020

"your other option is to not play, leave your money in cash and wait for better conditions":

Have enough capital to support retirement expenditure without earnings means not being forced to play.

The minimum capital to exceed the Age Pension at the ~$450,000 asset Sweet Spot is:
=PV(((1+1%/(1-47%)) / (1+1%)-1), (90-67), -37000-(((1+1%/(1-47%)) / (1+1%)-1) * 450000), -450000, 0)
= $1,217,540

which generates:
=PMT(((1+1%/(1-47%)) / (1+1%)-1), (90-67), -E34, 450000, 0)
=$40,951 / y

The Age Pension at the ~$450,000 asset Sweet Spot generates:
=37000 + ((1+1%/(1-47%)) / (1+1%)-1) * 450000
=$40,951 / y

Assumes minimal risk interest / return rates competitively determined by inflation and highest tax rates.

More income requires more capital or more risk.

October 09, 2020

which generates:
=PMT(((1+1%/(1-47%)) / (1+1%)-1), (90-67), -1217540, 450000, 0)

David Fraser
October 09, 2020

Great article and great replies. I am a 75 y.o. single member of a nearly 30 y.o. SMSF which has been in pension mode for 15 years. Because I only have me to look after the Fund’s investment strategy is risky and permits up to 86% weighting with just about anything on the ASX. I don’t touch bonds (mainly because of lack of understanding as to how they work) and I feel vindicated in that view after I recently read of the people ("Mums and Dads" like me) who lost money taking the advice of a large bond manger to invest in Virgin. I only invest in direct shares and long ago gave away the "set and forget" idea. I am not a day trader (but perhaps a half-yearly trader) who pays a full service broker 1% on trades which is probably too much. Mostly I decide on what to buy using the research from the broker (and elsewhere) and then I ask their opinion (my theory being that if they get it wrong - and they often do - I should not be too hard on myself because even the experts can stuff up!). When everything crashed and burned early this year I thought "wow" now is the time to top up my MQG holding at $75. Then APRA tells them to conserve their cash so they halve the dividend - proving the old saying there is no such thing as a free lunch!

Mark Beardow
October 08, 2020

Damien, as always well explained; my comment is that bonds aren't from Venus and equities from Mars......equity values have increased substantially due to lower yields, since bond yields peaked in the early 90s in AUS and early 80s in the US. Assuming bond yields rose to 6% and the equity discount rate rose by 6% too, what would happen to the valuation of equities? It's a low real return world what ever way you cut it.

Bill Nagle
October 08, 2020

An interesting Bank of England Working Paper out recently (2018?) looks at 800 years of interest rate data and it shows that the real interest rate trend is on an inexorable downward slide and heading to zero and staying there - sobering reading.

Damien Klassen
October 08, 2020

Staying at zero rather than going negative will be a win compared to what is happening throughout Europe!

Gary M
October 08, 2020

Thanks, Damien. Excellent article. I have been wondering about this traditional allocation and how it can be justified with bonds less than 1% and little to gain from further falls. Still leaves open the question of where to go. Non-investment grade?

Damien Klassen
October 08, 2020

* Corporate debt at record highs
* Unemployment (and more importantly underemployment) at highs not seen since the great depression
* Bankruptcies have been suspended throughout developed countries and are down 30-40% this year, which hasn't fixed the problem, merely delayed it.

I'm not a big fan of loading up on non-investment grade debt in that environment...
We just finished a podcast on your exact question:

Warren Bird
October 08, 2020

The 60/40 strategy isn't - or shouldn't have ever been - based on the idea that you'd make capital gains from bonds over time. Sure, as a volatility reducer - generating gains for a while when other assets are falling, then giving them back again when other assets are doing great - but not over time, when they don't exist. All bonds mature at par.

The challenge for 60/40 - indeed any allocation that includes 'income assets' - isn't that low yields reduce the chance of capital gains, it's that they deliver a low underlying income!

Two responses are typical - take more risk, put more into equities into to earn the allegedly reliable dividend stream. (But who else got their CBA dividend payment last week - it wasn't what you're used to, was it?) Or, become more 'nimble', don't set and forget but become more active. That relies on trusting the guru who promises that their nimble activities will add value rather than crunch your returns from another source.

If you believe in active management of asset allocation, then you'd do it already - even if yields are high - wouldn't you? I do, by the way (believe in some active asset allocation). But I actually think that the current climate makes it HARDER to add value from active asset allocation. At least not from anything that bonds are delivering. If you get the timing of the equity market's ups and downs right, then you can do something useful, but I've seen almost no one who's called the bond market right for over a decade, other than fixed income duration managers who actually understand the asset class. (Which is where you can be 'nimble'. Switching from equities to bonds isn't as easy as it sounds, but sliding up and down the curve within a bond fund is straightforward.)

I really don't understand the logic of arguing that the current investment climate argues for active management in some new sort of way. It's asserted a lot, including in this article, but far from proven.

Damien Klassen
October 08, 2020

Thanks Warren. You raise some interesting points. Believe me, the irony of buying bonds for capital growth and stocks for yield is not lost on me!

I'm not going to argue that tactical asset allocation is easier than it usually is in this environment. When everything is expensive it is definitely harder. But I do think tactical asset allocation will be better than a buy and hold strategy in this environment.

When markets are cheap, a buy and hold strategy will probably deliver you good returns. Maybe you could do better using tactical, but the returns will probably make you happy either way.

When markets are expensive, a buy and hold will probably deliver you poor returns. If you pick the wrong "guru" then you will do even worse. With the right tactical you have the possibility of earning an acceptable return. Or your other option is to not play, leave your money in cash and wait for better conditions. But that is a tactical asset decision in its own right!

Warren Bird
October 09, 2020

Thanks Damien. My view is that if returns are low, they're low. Let's stop pretending that there's a different way you can manage an investment portfolio to improve on that. It's a bit like cosmetic surgery or botox to try to make an older person look young again - it doesn't quite work! So if the expected returns over the next 10 years from your buy and hold 60/40 portfolio are, say, 3% today compared with 8% historically, exactly how much better than that is nimble active management of the asset allocation going to deliver? None of the funds that I'm involved with, professionally or personally, expect to get much more than an extra 1% per annum from active asset allocation and that's not from nimble short-term trading, but occasional adjustments when markets are really obviously out of line with reality. This is not a new approach to asset allocation - it's been going on for years. All the TAA funds that I used in my SMSF have been disappointing - they charge hefty fees to deliver supposedly superior returns using 'scientific' trading methodologies, and end up maybe reducing volatility a bit without any return enhancement. I've dumped most of them now and have moved to a more steady state asset allocation, which I'll adjust myself from time to time and save their fees! I've got more confidence in some value add from active management within each asset class, but this is just fund managers doing what they've always done - it's nothing new. Technology has made it feasible for some managers to tap into risk premia in a diversified way to generate a return profile uncorrelated with traditional assets and I do believe that adding something like that to the portfolio is potentially of value. But in short, I strongly believe that sticking to your knitting is the better strategy. And, if the next few years generate much poorer returns then it will be because bond yields have risen and share prices have fallen to more reasonable value levels in a better performing macro environment. That will set a 60/40 fund up for above-average returns for the next several years. As the saying goes, it's time in the market rather than timing the market .....


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