By Daren Fonda
Oct. 17, 2019
Bonds are poised to cause more trouble than they’re worth, and it may be time for investors with a 60/40 mix of stocks and bonds to replace them with other assets, including cyclical dividend stocks, junk bonds, and high-quality munis.
The 60/40 mix, an asset allocation once commonly recommended for retirement savers, "may have thrived in the 2000s and 2010s but won't survive the 2020s," Bank of America Merrill Lynch' Jared Woodard and Michael Hartnett assert.
The crux of this idea is that bonds aren’t likely to provide the diversification benefits and risk-adjusted returns that investors have come to expect. As Barron’s points out in this week’s cover story, a huge rally in global fixed-income markets has pushed yields down to near-record lows in the U.S. and below zero across Europe and Japan.
There is now $17 trillion of negatively yielding debt in global markets. The steep decline in yields over the past six months has been one of the fastest collapses since the global financial crisis, according to Woodard and Hartnett. Long-term Treasuries have rallied 28% in the past six months as yields have plunged.
This heightened volatility in bonds isn't what you want with a 60/40 portfolio. Bonds are supposed to provide ballast and capital protection against equity volatility, and if bonds are making big price moves, your portfolio could take some hits.
Merrill's rate strategists team expects 10-year Treasury yields to fall 0.25% in coming quarters to 1.25%. Low economic growth, a Federal Reserve that has been cutting rates, and relatively high U.S. yields compared with the rest of the world could continue sending yields down, Woodard and Hartnett write. Purchasing managers for manufacturers recently indicated one of the worst outlooks since 2009, they add, reinforcing the idea that the Fed will remain in easing mode.
Nonetheless, bonds may not be a great diversifier anymore. Stocks and bonds have had a negative correlation for the past two decades, Woodard and Hartnett write. But they had a positive correlation where they moved in the same direction for much of the postwar period.
It wouldn’t take much to push yields back up—a slight pickup in inflation forecasts or signs of a trade deal between the U.S. and China. And this is a twitchy bond market: A 10-year Treasury note bought Sept. 3 fell about 3% over the following 10 days—a big decline for an investment yielding 1.5% over the next 12 months, Woodard and Hartnett write.
So what are some other portfolio building blocks? Woodard and Hartnett say that stocks in high-yielding "bombed out" cyclical sectors with low multiples look attractive. That would be industrials, financials, and materials. Woodard and Hartnett expect those sectors to outperform technology and classically defensive stocks like utilities and consumer staples, which have been bid up sharply.
They also like short-term junk bonds and floating-rate loans. Yields are relatively low in junk bonds and bank loans "are reviled," they write. But credit risk is better than interest-rate risk and corporate leverage ratios have declined in certain non-growth sectors, indicating that defaults may not be as bad as expected.
As for floating-rate loans, there are worrying signs in the market. But Woodard and Hartnett view them as a “contrarian buy on plunging supply.” Loan yields would also rise if rates increase in 2020, supporting prices, an outcome that Woodard and Hartnett say is “underpriced” by the market.
High-quality munis could make a good substitute for Treasuries and investment-grade corporate bonds. Munis would benefit from a flight to quality. Merrill's fixed-income team expects them to rally at least to May 2020.
Granted, cyclical stocks, junk bonds and floating-rate notes are all "risk assets." They would sell off sharply in a risk-off climate as investors seek havens like Treasuries. Sure, it might look like 30-year Treasuries can't go much lower than the 2.2% they're now yielding. But they're not at zero yet.
Copyright 2019 Dow Jones & Company, Inc. All Rights Reserved.