Rates are hovering near or below zero throughout much of the world today. Low rates make life difficult for income-starved investors, and worse, they have called into the question the basic ability of traditional fixed income portfolios to meet investors’ expectations for income, capital preservation and diversification. In order to address what low yields have broken, investors must rethink their approach to building portfolios – and fix their fixed income.
Where will returns come from?
According to an FS Investments survey, investors expect an annual return of at least 7% from their portfolios.¹ Some of the world’s largest financial institutions, however, believe that the forward returns of a 60/40 portfolio will fall well short of 7%.
| Long term capital market assumptions1 | ||||
|---|---|---|---|---|
| Fixed income |
U.S. equities |
60/40 portfolio |
# of years |
|
| UBS | 1.4% | 4.9% | 3.5% | 5 |
| Northern Trust | 2.3% | 4.7 | 3.7% | 5 |
| Morgan Stanley | 1.5% | 4.6% | 3.4% | 7 |
| Bank of NY | 2.3% | 6.1% | 4.6% | 10 |
| JPMorgan | 2.8% | 7.2% | 5.4% | 10-15 |
Source: UBS, “Looking ahead: Intermediate projections of the economy and capital markets – five-year outlook,” as of June 23, 2020. Northern Trust, “Capital Market Assumptions: Five-Year Outlook,” 2021 edition. As of August 26, 2020. Graystone Consulting Global Investment Committee, a business of Morgan Stanley, “Annual Update of GIC Capital Market Assumptions,” as of April 1, 2020. BNY Mellon Wealth Management, “10-Year Capital Market Assumptions,” as of March 4, 2020. J.P. Morgan Asset Management, “LTCMA Mark-to-Market: COVID-19 – New cycle, new starting point” Executive Summary, as of April 30, 2020. Fixed income is represented by aggregate bonds or investment grade corporate bonds. An investment cannot be made directly in an index. U.S. equities are represented by large cap stocks. 60/40 portfolio refers to a traditional asset allocation consisting of 60% broadly to stocks and 40% to bonds.
With these projections in mind, it becomes clear that there is no easy path to generating 7% returns with a traditional 60/40 portfolio.¹
This data is for illustrative purposes only and is not indicative of any investment.
In order to better meet investors’ return expectations, advisors need to lower their return expectations for a traditional stock and bond portfolio – or look outside this traditional box to find solutions that can provide alternative sources of income, return and portfolio diversification.
A significant driver of these lower return expectations is that many investors expect rates to stay lower for longer.
Why is income so hard to find?
The spread of COVID-19 and the flood of government stimulus that followed acted as an accelerator to the 40-year secular decline in interest rates.
The Fed expanded its balance sheet by over $3 trillion in 2020, providing liquidity to banks and supporting bond prices through its open market purchases. That’s good news for the stabilization of financial markets, but the resulting low rates make the search for income even more difficult for investors.
Federal Reserve balance sheet
Source: U.S. Federal Reserve, as of August 19, 2020.
Where do rates go from here?
We all know rates can stay the same, rise or fall. Yet because of the historically low starting point for yields, bonds have significantly more risk to the downside if rates rise compared to the limited degree of return potential if rates fall.
Stay the same
The yield of the Barclays Agg has averaged 1%–2% in 2020.² Assuming prices remain stable, an investor’s return would be solely composed of coupon interest. Therefore, an equity portfolio would need to generate over 10% per year in order to reach the 7% return target of our surveyed investors.
1.15%
Barclays Agg Effective Yield¹
Rising rates
The duration of the Barclays Agg is at a multidecade high of approximately 6 years. If rates were to increase a modest 0.50%, the Agg would experience losses of 3% – completely wiping out returns.²
6.4 years
Barclays Agg duration¹
% change in bond prices if rates rise 1%¹
Falling rates
Rates already at historic lows leave little to no upside potential for investors. Falling rates also tend to indicate stress in the broader economy and financial markets, which would further challenge traditional portfolios from meeting investors’ return expectations.
U.S. Treasury yield curve remains depressed
This data is for illustrative purposes only and is not indicative of any investment. The above is based on the duration of each portfolio and the assumed changes in interest rates and does not consider other factors which may impact bond prices, including, but not limited to, credit performance, investor demand and market liquidity.
Ways to reshape a fixed income portfolio
Traditional fixed income portfolios have significantly more risk today than in any recent period due to the impact of low rates, which have increased the risk to the downside while offering little in the way of upside potential to cushion against future equity market pullbacks. The reshaped portfolio offers an attractive level of income and upside potential if rates were to stay the same or fall as well as downside protection if rates rise compared to a traditional fixed income portfolio. The illustration below shows the potential of complementing a traditional fixed income portfolio with assets that offer above-market yields and lower duration.
This data is for illustrative purposes only and is not indicative of any investment. The above is based on the duration of each portfolio and the assumed changes in interest rates and does not consider other factors which may impact bond prices, including, but not limited to, credit performance, investor demand and market liquidity. A Traditional Fixed Income portfolio is represented by the Bloomberg Barclays U.S. Aggregate Bond Index. A Reshaped Portfolio assumes a 50% allocation to the Barclays Agg and a 50% allocation to assets with a 6% yield and duration of 3 years.
There are many influences on bond performance, but one thing is clear: In order to create meaningfully different outcomes for a fixed income portfolio, advisors may want to consider a different approach.
Investors should work with their financial advisor to determine the right mix of traditional and alternative strategies based on their investment objectives.
Investor considerations
While traditional core fixed income investments can be accessed through low-cost passive strategies, many less-liquid and more-complex areas of the credit market require a skilled manager. An active manager with the flexibility to invest across the credit markets may help identify and invest in attractive opportunities beyond the scope of traditional core fixed income investments. A broad, multi-sector approach, such as a reshaped portfolio, may help generate income and diversify a traditional fixed income portfolio. However, as with any investment, the potential for a higher return also means higher risk.
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