Investment Strategy

Have you reassessed the role of bonds in your portfolio? You should.

Mar 15, 2022

Core bonds look more compelling. But the “reimagined 40” of a 60/40 portfolio can still deliver strong solutions.

Chris Seter, Fixed Income Strategist

Andrew Vanwazer, Managed Solutions Specialist

 

In a time of uncertainty and volatility—and by any definition, today’s market environment qualifies—it makes sense to re-evaluate your investment approach and, in particular, the role of fixed income in your portfolio.

Meeting the fixed income challenge

The traditional 60/40 approach (60% stocks, 40% bonds) continues to be challenged. That’s because in recent years, bonds have offered low yields and limited diversification benefits. Last year, we presented a potential solution to this challenge, the “reimagined 40.” This approach replaces a portion of your core bond allocation with riskier assets that offer greater income or appreciation potential. How big or small a portion depends on your risk tolerance and goals.

Reimagining the 40 has been successful, as the rising rate environment negatively impacted core fixed income. From January 1, 2021, through February 25, 2022, the U.S. Aggregate Bond Index1returned -5.5%,2while most solutions highlighted in the “reimagined 40” (outside of emerging market debt) posted positive returns.

Given the changing landscape, how should we evaluate the role of fixed income and the makeup of the “reimagined 40?” Bond yields have risen significantly, and higher yields make core fixed income more attractive. What’s more, the diversification benefits of fixed income have increased. While the U.S. economy is now solidly mid-cycle, those diversification benefits will be even more valuable as the business cycle matures. We advocate for starting to reduce core fixed income underweights as 10-year U.S. Treasury yields approach 2% and a neutral duration positioning between 2.25% and 2.5%.

At the same time, though, yields are still relatively low. Many investors want or need higher income/return out of their traditional fixed income allocations. For those investors, we continue to recommend a “reimagined 40” approach, with careful attention to allocation sizing. As always, the approach should align with your personal goals and risk tolerance.

How high might rates go?  

U.S. Treasury yields are a good proxy for the past year’s moves in government bonds globally. As of March 8, 2022, a two-year U.S. Treasury (UST) yields around 1.6%, up from 0.1% at the start of last year, and the 10-year UST yields 1.9%, up from 0.9%.3

Along with higher rates, investors have faced higher inflation across many developed markets. In the United States, consumer price inflation is at a 40-year high. Some observers believe 10-year U.S. Treasury rates might reach 4% or 5% as the Federal Reserve (Fed) looks to rein in inflation. We strongly disagree. We do not think interest rates will need to move substantially higher to control inflation. Indeed, we assign a near zero probability that yields on the 10-year UST can reach 4% or 5% this business cycle.

That’s largely because the neutral policy rate is substantially lower than it has been historically, just 2.7% in the last cycle versus an average of 4.5% over the prior two cycles, according to Fed estimates.4Here’s a brief explainer of this important economic concept:

The neutral rate is the rate that (theoretically) puts the economy in a longer-run equilibrium between overheating and slowing down. Rates above neutral restrict growth and inflation, rates below neutral stimulate growth and inflation. Central banks such as the Fed focus on the neutral rate in setting policy. Market-implied estimates of the neutral rate are roughly 1.80%. Our estimate of the neutral rate over this cycle: 2.25%.

The U.S. neutral rate has been declining for decades, for two primary reasons. The first is demographics—slower growth in the working age cohort as the U.S. population ages keeps a lid on economic growth and thus on policy rates. Productivity is the second important factor. It has been in a secular decline outside of the late 1990s.

An aging population keeps a lid on U.S. economic growth–and policy rates

Sources: Bloomberg Finance L.P., Bureau of Labor Statistics, Haver Analytics. Data as of December 31, 2021.
This chart shows the correlation between 10-year Treasury yields and the 10-year percentage change in the U.S. labor force since 1965. Both rose steadily from 1965 through the late 1970s, with labor force growth peaking about two years prior to the Treasury yield. Since peaking, both have steadily declined. The labor force projection, based on population growth, shows that the labor force is expected to grow at about the same rate as the 2010s during the 2020s.
While we see signs that productivity may improve in the coming cycle, it will take time to accrue to a stronger potential growth and higher neutral policy rate. Capital investment in software and automation relative to GDP is at the highest level on record, and COVID-19 has spawned migration trends that are likely to augment productivity.

Automation capex is picking up

Sources: BEA, CBO, Haver Analytics. Data as of December 31, 2021.
This chart shows private fixed investment in software, info processing, and research and development spending as a percentage of potential GDP since 1990. Automation capex rose from about 4.5% of potential GDP in 1990 to about 6.5% by 2001. It declined to 5.0% in 2002. It rose steadily over the past decade and is currently at a record high of 7.0%.
Even as the theoretical neutral rate has remained low, actual interest rates can still trade in a wide range over a single business cycle. Our model sees a range for the 10-year UST of 0.75%–3.00%.

We expect long-term rates to rise

Sources: Bloomberg Finance L.P., J.P. Morgan. Data is as of March 7, 2021.
This chart shows the 10-year Treasury yield since 2016. It has risen significantly since its record low of 0.5% in 2020. The chart includes our expected range for the 10-year Treasury across the business cycle, 0.75%–3.00%, and our Q4 2022 outlook, 2.30%.

Diversification matters even more as the expansion matures

Beyond yield, bonds provide the significant benefit of portfolio diversification. In most market environments, the prices of government bonds and equities are negatively correlated. That is, when stock prices fall, bond prices rise (and yields fall). While core fixed income can provide portfolio diversification through all stages of the economic cycle, the benefit increases as economic expansions mature. Although we consider the U.S. economy to be in mid-cycle, the cycle is moving forward faster than we expected. A wage-price inflation spiral is not our base case. But the risk of this happening isn’t zero, either. Should it occur, it would only accelerate the cycle.

The total return in 10-year USTs, if rates decline to their lower bound, has doubled since the start of 2021. This suggests a significant increase in the potential benefit of diversification.

The potential diversification benefit of the 10-year UST has improved since 2021

Source: Bloomberg Finance L.P. Data as of March 11, 2022. *Defined by when our Business Cycle Index was at a similar level to current value.
The potential return if yields decline to their lower bound today is about double the potential return from the start of 2021.

What do higher bonds yields mean for the “reimagined 40”?

Let’s recap. Bond yields are higher than they were a year ago, which means the relative value gap between core fixed income and risk assets has tightened over the past year. Does that diminish the case for a “reimagined 40?” We don’t think so. If you can take on slightly greater risk and give up some liquidity to get higher yields or returns, we believe a “reimagined 40” allocation can still provide better returns over the long term.

When you set up or reassess your “reimagined 40” strategy, be sure to focus on two important issues.

Allocation sizing

Remember, this is a “reimagined 40” strategy, not a “replaced 40” strategy. Pay attention to allocation sizing. You want to be certain that market moves have not effectively eroded the role of core bonds in your portfolio. Look at what has happened recently as Russia’s invasion of Ukraine weighed on risk appetite. Many of the “reimagined 40” strategies rallied significantly over the last year, and thus may represent a bigger portion of your portfolio than you intended.

Strategy opportunities in public and private markets

Private investments can deliver a critical component of a “reimagined 40” solution set.

Real estate continues to be a preferred opportunity within privates, and it may be even more attractive today than it was a year ago, given today’s higher inflation (with U.S. CPI at a 40-year high). Like other real assets (infrastructure and timber, for example), real estate’s value tends to rise in an inflationary environment for two main reasons. First, the replacement cost increases, and the supply of real estate is more or less fixed in the short run. Second, real estate cash flows tend to keep up with inflation because landlords can usually increase rents when inflation picks up.

Taking the next steps

As interest rates have risen over the past year, core fixed income has become more attractive. But if you want or need higher income/return out of your fixed income allocation, a “reimagined 40” approach can still be an effective solution. Both income and portfolio diversification are on offer across a wide range of asset classes and strategies.

Think about your personal goals, short-term and long-term, and your risk tolerance over different time horizons. Your J.P. Morgan team can discuss what core fixed income and “reimagined 40” strategies might be right for you.

 

1The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and nonagency). Provided the necessary inclusion rules are met, US Aggregate-eligible securities also contribute to the multicurrency Global Aggregate Index and the US Universal Index, which includes high yield and emerging markets debt. The US Aggregate Index was created in 1986 with history backfilled to January 1,1976.

2Source: Bloomberg Finance L.P. Data as of February 25, 2022.

3Source: Bloomberg Finance L.P. Data as of March 8, 2022.

4Based on the Federal Reserve Laubach-Williams model estimate + a 2% inflation rate.

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