Low Interest Rates: The New Challenge for the Classic 60/40 Portfolio

By: Steve Karsh, MBA, Principal

For the past 40 years, many individuals and institutions have invested in the classic 60/40 portfolio (60% U.S. Stocks / 40% High Quality U.S. Bonds).   This classic mix of stocks and bonds has historically been a relatively safe moderate return and risk portfolio earning an annualized return of 10.4%*. Even over a shorter time-period of the last 22 ½ years (August 1998 – March 2020) which has included three stock market declines of at least 30%, the 60/40 portfolio has returned an average of 6%.  For public non-profit institutions that spend at least 5% of their corpus, the classic 60/40 portfolio has been more than adequate to meet those needs with moderate risk while being able to grow the corpus.  And for individuals, it has allowed for a solid nest egg to be built up; an initial investment of $100,000 in 1980 would be worth over $5.2 million today**

Breaking down the return components, stocks have returned an average of 11.8% per year and bonds have returned 7.5%.  While stock returns can vary widely from year to year and are the riskier part of the portfolio, bonds have traditionally played the anchor role and are much less volatile, creating a moderately risky portfolio.  When looking at bond returns for the past 40 years it is easy to see why the 60/40 portfolio has done well.  As interest rates have steadily come down, the value of the bonds in their portfolio went up.  The chart below shows the decline in interest rates and the return of the Bloomberg Barclays’s Aggregate Bond Index.

Sources: Investment Metrics and MacroTrends.net and Treasury.gov

That is the good news…

Although interest rates have been declining for decades, the COVID 19 pandemic caused them to plummet to all-time lows.  At the end of 2019, the yield on the 10 Yr. Treasury was 1.92% and on March 9, 2020 it dropped to a new low of 0.54%, a decline of 72%.  That does not bode well for bond returns going forward.  The chart below shows starting yields and their subsequent 5-year returns. 

Source: J.P. Morgan Asset Management

The key takeaway is the lower the starting yield, the lower the expected return assuming no change in interest rates.  Should rates rise from historic lows, the picture for bond returns becomes even less appealing.

Source: J.P. Morgan Asset Management

What does this mean for a 60/40 portfolio going forward?  If rates were to go up 1% for example, stocks would have to average close to 7% to earn a total return of 5% or if rates go up 1.5% stocks would need to average close to 8% to earn a total return of 5%.  For moderately risk tolerant investors accustomed to an almost 10.5% return over the past 40 years, they may be in for a “new normal” low return environment.  Those non-profit’s that need to spend 5% will not see their corpus grow, individuals building up their nest egg will need to be more patient and those in retirement who depend on the income generated from bonds may need to adjust their spending down from the typical 4-5%.  The alternative of course is to increase the allocation to stocks, which increases the overall risk of the portfolio.  Alternatively, investors may need to look to alternative allocations with investments that have higher yields than bonds as well as investments that are not as highly correlated to the stock market to generate better risk adjusted returns.

* Assumes annual rebalancing (Jan 1, 1980 – December 31, 2019.

** Assumes $100,000 investment on 1/1/1980 with no additions or withdrawals and ignores any tax implications.  Portfolio is assumed to be rebalanced annually on Jan 1 each year.