The 60/40 Retirement Portfolio Is Dead. Why And What To Do Next?
Seeking Alpha Analyst Since 2013
Summary
- "Lower for Longer" Interest Rates has dramatic implications for retirement portfolios.
- The 40 year bull market in bonds is over, investors must adapt.
- New "Risk" Allocations vs. traditional "Asset" Allocations will allow retirees to achieve income goals and reduce portfolio volatility.
“This period, like the 1930-45 period, is a period in which I think you’d be pretty crazy to hold bonds, if you’re holding a bond that gives you no interest rate, or a negative interest rate, and they’re producing a lot of currency and you’re going to receive that, why would you hold that bond?” Ray Dalio – CIO Bridgewater Capital
“Bonds are now the risky part of the portfolio” – Leon Coopeman – CIO Omega Advisors
There is ample debate among pundits, media personalities, politicians, and the general public about which, quarantine induced, societal changes will become permanent. Will the “All You Can Eat Buffett” become a relic of a bygone era, will the “face to face” sales meeting be replaced by a long distance ZOOM call, will at home interactive exercise replace the gym. While we don’t suppose to be able to make an informed prediction on the permanence of any of these changes we do think there is one extremely important change in financial markets, precipitated by the crisis, which we believe is permanent and will have a major impact on the retirement plans of every person currently retired or about to retire.
That change is the significant decline in interest rates and the fact that the fixed income portion of an investors portfolio is at best low return and at worst high risk. In just the last 18 months, the yield on a 10 YR Treasury has declined from 3.25% to .65% today. That 80% decline in interest rates will have a major impact on every financial plan in existence and if it is not addressed will make the output of those plans as obsolete as the handshake.
This article examines why this decline in rates, accelerated and made permanent by the Covid-19 Pandemic, is so important for investors to understand and take steps to mitigate.
To examine how we got to the current “low reward” environment in bonds we need to look at the history of interest rates and why the 40 year “bull market” in bonds is likely near its peak.
To understand how interest rates reached such high levels by 1980 we start in the mid 1970’s when several ill-conceived economic policies, the increased power of OPEC to control oil prices, and reduced confidence in the US Dollar resulted in a period of hyperinflation in the United States. By 1973, domestic inflation was running at about 8%, by 1974 the number climbed to 12%, and peaked at 14% in 1980 (for comparison, the current Fed has had difficulty achieving even a 2% inflation rate) This inflation caused major dislocations in the domestic economy. To arrest the inflation, Fed Chairman Paul Volker, embarked on an aggressive rate hike cycle. Between 1979 and 1981 Volker raised the Fed funds rate from 10% to 20%. The Chairman’s efforts lead to a severe recession in the early 80’s but did stop the inflationary cycle and set the stage for a 40-year bull market in bonds. The chart below gives some perspective on how big an anomaly 20% rates were.
This period of inflation, followed by the rate hikes to subdue it, skewed the return on fixed income over the next 40 years. The chart below shows nominal returns in Treasuries since the 1920’s. You can see that the high starting point for rates in 1980, and the relentless downward pressure since then, lead to outsized returns compared to previous periods. These returns cannot be replicated in coming decades without rates making a similar upward move first, a result which would devastate the value of a clients current fixed income holdings.
The returns since 1979 were double the returns in the previous 40 years.
Further marginalizing the utility of bonds in retirement portfolios is that the cash flow generated from these instruments has become nearly nonexistent. The chart below demonstrates the cash flow from a US Treasury portfolio over the last several decades. As recently as the turn of the century a $1mm bond portfolio could have provided a significant portion of a retiree’s necessary income. Today, that same portfolio would provide 1/10th the income it would have in 2000 and that doesn’t even account for inflation!
In general, forward 10-year bond returns will closely mirror the coupon rate at the start of the period. This statement should not be surprising. That means, investors should expect a return on their bond portfolio, over at least the next decade, of about 60 basis points or .60% per year. Even if we assume that stocks return a consistent 7% per year a 60% Equites - 40% Bonds portfolio would produce about a 4% annual return and a more common retirement portfolio of 40/60 would produce about a 3% return. On a $1mm portfolio you would anticipate $30,000 in annual returns, hardly the basis for a comfortable retirement. And, this does not account for the year to year variance in returns in equites, variance which must be endured to achieve the 7% long term returns. More likely a 60/40 portfolio would expect several years with negative returns to achieve the long-term results.
With such a low yield there is little reward in bonds even if the overall macro environment remains stable. If inflation becomes a problem or if the US$ becomes less attractive as a global reserve currency, there could be significant downside risk. We believe this sets up a period of low reward/high risk in the bond market, not the make-up of the asset class which is supposed to provide you stability and consistency.
In fact, the risk in bonds is much higher than it has been for 50 years.
The two factors with the most direct influence on the value of a bond are interest rates and inflation. While the movement of rates is important, higher rates leading to lower prices, it is really inflation which has the most direct impact on the “real” return of your bond portfolio. Stated inflation has been benign for at least the last 20-30 years. Global phenomenon such as, increased productivity, globalization of supply chains and other scientific improvements has limited inflation. With stated inflation below 2%, in the last decade, even a 2 or 3% yield was still producing a positive real return. However, with Treasury rates well below 1% and 13 Trillion Dollars in global bonds trading with a negative rate, investors buying these bonds are signing up to lose money on a real basis. While this may sound strange, a historical review of real bond returns demonstrates that negative real rates are not that unusual.
As you can see, real returns in bonds were strongly negative from 1940 – 1979. The drivers of these negative returns were largely the same circumstances we find ourselves in today, a low starting point for rates and a significant increase in fiscal and monetary stimulus. While we do not necessarily believe that real returns will be as deeply negative in coming years it is important to understand this has happened before and to be prepared. It is also important to realize that with returns so low and the potential for significant downside, the risk to reward is heavily skewed to risk. For negative yielding bonds future returns are dependent on new buyers pushing rates even lower, not on cash flows from the bonds themselves.
Who are the buyers of an asset that you must pay to hold? Mostly large institutions mandated by regulatory authorities to retain a certain portion of their assets in the highest rated sectors of the bond market. Traditionally, these highly rated sectors are held as reserves for insurers and pension managers. Today, they are amongst the markets highest long term risks.
While not as predictable, it would be easy to argue that there are also several macro forces which could pressure inflation higher. The most obvious of those is the massive Fed stimulus to fight the economic effects of Covid-19. The chart below demonstrates the exponential increase in the Fed’s balance sheet since the great financial crisis in ’08.
You can see that Fed grew their balance sheet by about 400% in 13 years and then doubled it again in the last few months. This massive increase in liquidity has driven up prices in risk assets and kept rates on fixed income assets down. However, how this increase will affect the US$ and inflation going forward is still unknown. We do know it won’t be deflationary in the short term and that even the best outcome for bonds is just a very low return.
Another macro issue, which could pressure bond prices, is the ongoing and increasing acrimony between the US and China, the second largest foreign holder of US debt. Given the rapid increase in our debt, it is difficult to think that a more antagonistic relationship with one of the largest owners of that debt will increase the likelihood of lower rates in the future.
The chart above shows the top foreign holders of domestic US Treasuries. Interestingly, the largest holder is now Japan, recently surpassing China. Japanese institutions have been forced into US debt by their own Central Bank, which has been aggressively repressing rates at home through its own balance sheet expansion. Even low yielding US debt has been more attractive than zero or negative yielding Japanese debt. Now that the yield spread between US and Japan is almost non-existent, how long will the Japanese continue buying US debt?
In higher risk bonds reduced rates diminish the ability of these lower rated bonds to realize outsized returns in the face of eventual defaults. When Michael Milken pioneered the high yield or “junk bond” space his thesis was that the outsized yields would more than make up for the default risk. However, with yields so low, there is no longer any cushion to mitigate those defaults. This makes the high yield, or “junk”, sector even more dangerous then usual.
We now know that bonds are low reward, high risk but what are investors to do who need returns on their retirement savings to fund their lifestyle post work. With the decline of defined benefit plans, like a pension, the onus is on the individual investor and their financial planner to utilize those savings to create a consistent income stream for retirement. Traditionally, the most effective way to generate consistent, low risk, income would be through fixed income instruments. In stable inflation and interest rate environments an investor could make accurate predictions about the amount and timing of income from their retirement savings. When interest rates were higher, as they have been over the last 40 years, the interest income form this portfolio could provide a large portion of a retiree’s necessary income. Today, that income in substantially reduced from prior decades. Currently income from 10 Yr. US Treasuries is about 1/10th of what it was in the early 80’s.
With little income from bonds we believe retirees have two options to generate the returns they will need to fund their retirement. The first option is to increase their portfolio allocation to equities. Since equites have higher long term returns an investor could get similar results to what they might expect from a 60/40 (Stocks/Bonds) portfolio with a 75/25 (Stocks/Cash) portfolio. The idea here is that you can make up for increased volatility in the stock portfolio by carrying a higher cash position and planning to draw against that cash during equity drawdowns to avoid inopportune sales. We believe this is a bad option. While we are proponents of equities for the long-term increasing equity allocations in retirement portfolios leads to a myriad of other issues. Those issues include, sequence of return risk, increase in volatility, less diversification and many more.
While the current group of retirees and near retirees are certainly at a disadvantage vs. previous generations, from the perspective of available stable income instruments, they are fortunate that a number of new alternative investment vehicles have become available to individual investors in the last few years. Sterneck Capital has done extensive diligence on these vehicles and has created a proprietary basket of investments. This basket is significantly accretive to a retiree and near retiree’s portfolio. Importantly, they are diversifiers to an individual’s existing portfolio. Combining these assets with traditional assets provides a differentiated return stream and results in a narrower range of outcomes.
The charts below show a Monte Carlo analysis of the hypothetical portfolio of 50% SP500 and 50% our basket of alternatives vs. 75% equity and 25% cash. The portfolios produce similar expected returns, but the higher volatility of the equity returns means more variable results and a wider range of outcomes. This wider range can have a significant effect on a retiree, making planning and budgeting difficult.
For holders of a diversified retirement portfolio a mix of equities and alternatives is clearly the preferred allocation.
For high net worth clients, looking to substitute for the high risk, low reward, bonds in their current portfolio, the chart below looks at the historical returns of our basket of alts vs. the fixed income benchmark, the Barclay’s AGG (AGG) As you can see, our basket produced a higher return and a lower standard deviation (volatility) then the AGG.
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