Bond yields are the highest they’ve been in 15 years, and stocks appear less expensive than before. The odds are now in favor of the balanced portfolio.

Last year was bruising for investors across the board. With the S&P 500 down 19%, the Nasdaq lower by 33% and the Bloomberg U.S. Aggregate Bond Index down 13%, there weren’t too many places left to hide in 2022. One of the dominant narratives was the apparent breakdown of the traditional 60/40 portfolio, meaning a composition of 60% stocks and 40% bonds. Investors with this allocation experienced a portfolio decline akin to the great financial crisis of 2008!

While it is understandable to question whether the 60/40 balanced portfolio strategy is fit for a given purpose, a strong case can be made that it was not 2022 where the strategy failed due to rising interest rates and market performance, but rather, the decade or more prior. A long period of historically low interest rates had compressed bond yields and income. In reality, there likely hasn’t been a better time for investors to construct a 60/40 portfolio than in 2023, as bond yields are the highest they’ve been in 15 years, and stocks appear less expensive than before, if not objectively cheap.

The Federal Reserve’s previous low-interest-rate policy, various rounds of quantitative easing (effectively a constant devouring of mortgage-backed securities, bank debt and Treasuries) and general COVID-19 response inflated all security prices, lowered bond yields and pushed investors into taking further risk in order to meet their required return.

The inconvenient truth is that almost all investor returns have come from equities. So even though the balanced portfolio has done well in this time period, investors were rewarded for increasing their risk rather than sticking to the prescribed asset allocation.

What the Federal Funds Rate Does

The federal funds rate, determined by the Federal Reserve Open Market Committee, is the rate at which commercial banks lend to institutions overnight. Effectively, this rate determines the short cost of capital for the broader economy. When kept low, it stimulates the economy and aids capital formation. When the rate is higher, it slows down the economy. This rather blunt instrument of the Fed raising interest rates is the best tool the Federal Reserve has to tackle the currently dominant issue of inflation.

Interest-rate-hike cycles have occurred many times over the past 40 years without leading to the carnage of 2022. But the breakneck speed of the current hiking cycle moved from 0-0.25% in March 2022 to 4.75%-5% in March 2023. These actions dramatically repriced credit markets and largely created the 13% decline in the overall bond market in 2022.

So how can investors feel comfortable allocating to two asset classes that each had meaningful declines last year? Well, it’s important to understand the fundamental difference in risk profile. Yes, stocks finished 2022 down 19% (and even more at certain intervals), but that level of volatility is not atypical in itself. We observe intrayear movements of as much as 20% on a regular basis as various emotions play out in the markets, so the long-term average projected return is somewhat misleading.

When on a bumpy flight down to a warmer climate, I am reminded of the experience of investing in equities: frequently uncomfortable but ultimately successful. Investors need to stick with equities through good times and bad in order to benefit from the long-term compounding produced by business growth and innovation.

Investing in bonds is a different story. There are two primary reasons why investors would allocate 40% of their portfolio to bonds. One is income: A portfolio nearing the distribution phase ought to generate a reasonable amount of income to help satisfy these distributions so the rest of the portfolio can maintain its seat at the high table of compound returns.

What Bonds Are Supposed to Do

The other reason is that bonds are supposed to be reasonably uncorrelated with stocks and thus could generally be expected to offset the sharp movements observed in stocks. If we have a year when the stock market goes down 20%, history suggests that bonds may be flat or possibly up about 1%. In such a scenario, our overall portfolio would decline less than 12%, so we would live to fight another day and participate in an eventual recovery of stocks. But if bonds didn’t perform like this in 2022, should we be afraid of the same thing happening again in 2023?

Most bond investors take a buy-and-hold approach. Diversification is created not just via issuer, but via maturity as well. Ideally, we would hold each bond to maturity. If you have a high-quality bond with an unrealized loss, it is due to changes in the interest-rate environment and the required return of the bond market.

The market expects a 5% yield, but your bonds coupon is less than that, so it will trade at a discount. But unlike stocks, bonds will mature. And unless there is a problem with the specific issuer, they will mature at par (face value). So, if you paid par, your unrealized loss will reduce over time and ultimately be erased.

In 2023, we have an opportunity that hasn’t presented itself since before 2008. Investment-grade corporate bonds, shorter-term U.S. Treasuries and municipal bonds all have attractive yields and provide investors with a full menu from which to build a flexible portfolio with various maturities.

Capturing a return from the fixed-income side of the portfolio in the neighborhood of 5% actually creates more flexibility to be discriminating when investing in equities. Investors should not feel the need to chase speculative, unprofitable companies or those with declining businesses.

A fixed-income allocation that pulls its weight allows for an equity allocation focused on quality. And quality investments can mean the difference between fleeting volatility and permanent capital impairment. Short-term market movements are always tough to predict, but investors considering a 60/40 portfolio should note that the odds are more favorable now than they have been in many years.

About the Author: Mel Casey, CFA, CAIA – Mel brings nearly two decades of financial services and investing experience to the FBB team. As a Senior Portfolio Manager, Mel is responsible for managing client relationships and client investment portfolios. Prior to FBB Capital Partners, Mel spent several years at 1919 Investment Counsel where he managed individual and institutional client portfolios, a Financial Services Mutual Fund and a Real Estate Equity Strategy. Prior to his time with 1919, Mel held various roles with investment banks Keefe, Bruyette & Woods and Compass Point Research in New York and Washington, DC respectively. A native of Dublin, Ireland, Mel received his Bachelor of Commerce degree from University College Dublin. He is a CFA®, and CAIA charterholder, a member of the CFA Institute, and a member of the CFA Society of Washington, DC. Mel lives in Bethesda, Maryland with his wife Jenny and their two children.