For decades, the 40% in the traditional 60/40 portfolio construction model was supposed to provide stable income with reduced volatility. But these days, finding income in the usual areas is as hard for me as a professional investor as it is for our clients.
With yields at historic lows, we’re forced to choose between accepting lower income or expanding into higher risk asset classes. We need to work together to change the definition of the 40 in the 60/40 split. So what do we do?
Cast a Wider Net for Income
We must add new sources, new asset classes, more complexity and potentially more risk — but this also gives us the opportunity to build more diversified portfolios. Consider different areas of the fixed income landscape, dividend-paying equities and alternatives such as real estate, real assets and private credit.
In casting a wider net, however, advisors should understand the risks they are taking on and how these risks work together. As part of our investment process, we broadly sort possible asset classes into three buckets: interest rate risk, credit risk and equity risk. Each offers different yield and volatility profiles, and we suggest investors diversify across different income opportunities and risks.
Putting It All Together
To construct an overall portfolio, advisors should first take a hard look at the investor’s risk tolerance and goals. Are they better off with a portfolio containing mainly interest rate risk and lower volatility, or do they want to add credit and equity risk to increase the yield potential, as well as volatility?
The Mid-Quality Sweet Spot Emerges
Two distinct sides of the market have emerged from the coronavirus crisis. The highest quality segment — like U.S. Treasuries and agency mortgage-backed securities — has already benefited extensively from the Federal Reserve’s rate cuts and direct purchase programs, but offers little yield.
The Fed said it will keep short-term rates at 0% through the end of 2022, and Treasury purchases remain robust. We believe rates may remain at zero beyond 2022, as the Fed is currently reviewing its policy framework. That means high-quality bond yields won’t be increasing substantially any time soon.
The lower-quality, more credit-oriented asset classes offer more generous yields, but defaults may become an issue. That doesn’t mean we aren’t still finding solid investments in those lower quality areas. It just means we have to roll up our sleeves and dig deeper to find them than we did a few years ago.
Given the dilemma of high quality with low yields vs. low quality with higher defaults, we think mid-quality assets offer better relative value. Why?
- Many of these in-between quality assets will benefit from Fed actions.
- The mid-quality profile offers higher yield than Treasuries without the heightened credit risk of lower-quality tiers.
- These assets have more room to recover as the economy gradually improves, but don’t carry the potential credit impairments.
Look for a Gradual, Bumpy Global Recovery
We expect U.S. economic activity to return to its fourth quarter 2019 peak in the second half of 2021, clocking this recovery at twice the speed of the one that began in mid-2009. While that forecast might appear optimistic, unemployment will likely remain between 8% and 10% through much of 2021.
At the end of the day, economic policy will determine the speed and trajectory of this recovery. With reopening underway, policymakers will need to do more to ensure financial conditions don’t worsen, and lend assistance to cushion the demand shock.
With all that said, what do we suggest advisors do with investor portfolios?
- Maintain a generally neutral duration position and take on credit risk selectively.
- Seek credits with durable free cash flow and solid balance sheets across a variety of areas.
- Explore investment-grade corporate credit, mortgage- and asset-backed securities, preferred securities and emerging markets, with a tilt toward dollar-denominated debt.
Tony Rodriguez oversees fixed income strategy for Nuveen’s global fixed income team and is responsible for co-chairing the Investment Committee, which establishes investment policy for all global fixed income products, and communicating the team’s positioning.