Alcohol, the philosopher Homer Simpson once observed, is both the cause of and the solution to all of life’s problems. I’m not sure about that bit of wisdom, but a drink or two can help smooth off some of the day’s rough edges.
The same can be said for bonds in a balanced portfolio. More often than not, rising bond yields hurt stocks while falling yields bolster the prices of equities. And for the better part of the past four decades, since bond yields touched their all-time highs, fixed-income securities have helped to soften the blows of downturns in stocks. All of which has accounted for the enduring popularity of the classic investment cocktail of 60% equities to 40% fixed-income securities.
Yet, as this column has been discussing since early 2018, that past may not be prologue if bonds and stocks cease to be negatively correlated (which is how M.B.A.s complicate what happens when one asset class zigs and the other zags). The quarter just ended is a good example of how bonds not only failed to cushion shocks to the stock market but actually caused them.
The backup in the benchmark 10-year Treasury note yield to 1.55% from 1.30% in September resulted in the worst month for stocks since the pandemic plunge of March 2020. So the twin declines in bonds and stocks failed to offset each other.
For instance, to cite investible examples, the Vanguard Balanced Index fund (ticker: VBIAX), which hews to a 60/40 formula tracking the CRSP Total Market Index and the Bloomberg Barclays Aggregate Bond Index, had a negative total return of 3.11% last month, according to Morningstar data. The Vanguard Total Stock Market Index fund (VTSAX), which also uses the CRSP index of some 4,000 stocks from mega- to micro-cap rather than 500 handpicked big names, suffered a negative return of 4.49%. And the Vanguard Total Bond Market Index fund (VBTLX), which also uses the venerable Agg—as fixed-income types call it—was off by 0.90% for the month.
After a September that bulls would rather not remember, the third quarter basically came to nothing. For the Vanguard Balanced fund, it was a hair less, actually, with a negative 0.03% return, while the Total Stock fund had a negative 0.07%, offset partially by a positive 0.11% from the Total Bond fund. And over the past 12 months, the bond index’s negative 0.92% return was blown away by the 32.08% surge that took off with the announcement of vaccines for Covid-19 and the subsequent economic reopening. As a result, the balanced fund still turned in a credible 17.97% return for the latest 12 months.
Over the longer term, however, the balanced portfolio suffered less of a drag from bonds, which performed their shock-absorber function. For the past five years, the Vanguard balanced fund returned 11.42% per year, while the equity counterpart returned 16.87% annually and the fixed-income index fund returned 2.93%. Over the past 10 years, the results were remarkably similar, with 11.22% a year for the balanced fund, 16.60% for the stock index fund, and 2.96% for the bond index fund. Many pensions and endowments wish they turned in results as good.
Whether the mixture will work as well in the future as it has in the past is something investors need to contemplate. What’s different now is quite simply that bond yields have far less room to fall and are more likely to rise (and bond prices to decline), especially if inflation proves to be more than transitory. Looking at the past 10 years, the Treasury 10-year yield moved in a band roughly between 1.50% and a bit over 3%—until it collapsed with Covid to a record low just over 0.50% at the end of July 2020.
Will the benchmark remain contained in that band of 0.50% to 1.60% (where it was trading Friday morning)? In real terms, the 10-year Treasury inflation-protected securities (TIPS) yield is a bit above the record low of minus 1.16% touched in early August, at minus 0.90%—still deeper in negative territory than previous lows registered in 2012.
As for the other component of bond yields—inflation—the Federal Reserve has tacked in a way inconceivable to central bankers not so long ago to encourage inflation to exceed the previous 2% target. So far, this has been a success. The latest median Federal Open Market Committee forecast is for its favored inflation gauge, the personal consumption (PCE) deflator, to rise 4.2% in 2021. But in keeping with the panel’s expectations that the inflation surge will prove transitory, the median forecast is for the PCE to slow to a 2.2% pace in 2022 and 2023 and 2.1% in 2024.
The TIPS market looks for somewhat higher inflation, however. The five-year break-even rate—the difference between the nominal Treasury yield and the corresponding TIPS—is 2.61%. And for the subsequent five years, the market is forecasting 2.31%. (It should be noted that the relevant inflation gauge for TIPS is the consumer-price index, which runs a bit higher than the PCE deflator.)
So will real yields remain subzero for the long-term? Will inflation follow the Fed’s anticipated benign glide path? If it doesn’t, bonds may be less of a buffer for volatile stocks.
Gold and TIPS were previously recommended as better hedges than bonds, but that’s been only half right. The iShares TIPS Bond exchange-traded fund (TIP) has returned 4.88% for the 12 months through Sept. 30, while the SPDR Gold ETF (GLD) has had a negative 7.26% total return over that span.
J.P. Morgan strategists found in mid-2020 that a better hedge for most equity portfolios was a combination of then-out-of-favor groups—value stocks, financials, industrials, small-caps, and materials stocks. The total-return scorecard for representative ETFs for the 12 months through Sept. 30: Vanguard Value (VTV), 32.59%; Financial Select Sector SPDR (XLF), 58.76%; Industrial Select Sector SPDR (XLI), 28.84%; iShares Russell 2000 (IWM), 47.43%; and Vanguard Materials (VAW), 30.85%.
None of those groups could be considered out of favor anymore, but they should benefit from a continued economic recovery. In that case, bonds should continue to be a drag on balanced portfolios. So, have a drink as you consider your strategy.
Write to Randall W. Forsyth at [email protected]
