Rethinking the 40% bond allocation

The Federal Reserve’s unprecedented monetary policy and stimulus support in 2020 has effectively upended traditional notions of a balanced portfolio of 60% stocks and 40% bonds.

That was among the takeaways from a virtual panel discussion Wednesday during Morningstar’s annual conference.

Panelists Rick Rieder, chief investment officer of global fixed income at BlackRock, and Anne Mathias, senior strategist and member of the fixed income group at Vanguard, both support the Fed’s emergency efforts to pump money into the economy in the wake of the pandemic-forced economic shutdown.

Rieder and Mathias also agree that there is much more stimulus to come, which is why financial advisers need to be bracing client portfolios for the fallout, especially on the fixed income side.

“I think people underestimate how significant the stimulus has been, and I think the Fed has done an A-plus job,” said Rieder. “I think the fiscal stimulus is really important, and whoever is president next, we’re going to get more stimulus.”

Mathias, who referred to the multi-layered stimulus programs aimed at putting money into the pockets of consumers as “the equivalent of helicopter money” dropped from the sky, said this is only the beginning.

“The way it has been structured creates an environment where it has to continue for a while,” she said. “There’s a fascinating contrast to the U.S. response which was focused on supporting the consumer with this flood of money with China that focused on manufacturing support.”

Even acknowledging the stimulus “sugar high” that equates to “borrowing growth from the future,” Mathias said, the stimulus has to continue in order to prevent a sudden drop off in consumer spending, which means a drop off in economic growth.

Part of the bottomless stimulus bucket is a scenario where “the Fed is not going to be pressured to raise rates for a very, very, very long time,” Mathia said.

“This creates an environment where the Fed doesn’t have to raise rates and where it’s harder for the market to predict what the Fed is going to do,” she added. “You’ll have this environment where nominal rates will stay just below where they normally would be, and financial conditions will be important, because we’ll be asking ourselves how much of an asset price bubble will the Fed be able to tolerate.”

The risks, or flipside, of the Fed’s stimulus support is fixed income market that looks like a barren wasteland for income-seeking investors.

“I think the portfolio you had a year ago has to be really different from the portfolio you have today, because I’m not sure I want to follow the Fed at 27 basis points,” said Rieder. “You have to build a cushion in other parts of the portfolio and find real income.”

He advised against chasing too far into the high-yield bond market because that trade has already made junk bonds too rich for the yield they are paying.

“You have to be real careful about where you’re putting dollars,” Rieder added. “Having some inflation protection in the portfolio by owning some [Treasury Inflation-Protected Securities] makes sense.”

He also gave a nod toward gold and dividend-paying equities as a replacement for part of the bond allocation.

“I think equities make more sense in a portfolio today, and I think alternatives will take a bigger portion of the 40% bond slice,” Rieder said. “Fixed income still works, it’s just gotta be smaller.”

Mathias also believes a smart defensive play is an allocation to Treasury Inflation-Protected Securities, and she said that the current environment paves the way for active management in the fixed income space.

“I think this is the golden age for active investing in fixed income,” she said. “What really matters now is security selection, because you’re not getting paid for beta so hiding out and trying to find your return by capturing beta is not the way to go.”

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