It’s time to tilt portfolios more into bonds

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The writer is chief economist and head of the investment strategy group at Vanguard Europe

Almost everyone in the markets seems to believe that interest rates are close to surpassing recent peaks. Central banks are expected to cut interest rates as they gain confidence that inflation is on track. Some, such as the European Central Bank and the Bank of England, have already started. The most important central bank, the US Federal Reserve, is likely to start cutting its benchmark rate next month from the current range of 5.25 to 5.5%.

Rates are likely to settle at or near what is known as the neutral rate, or r-star, the level that neither stimulates nor constrains the economy. Importantly, although rates will fall, they will not reach as low as before the Covid pandemic. We are entering a new regime where bonds provide greater value in a portfolio.

How does a high rate regime affect portfolio choice? History is a good place to start.

My colleague Dimitris Korovilas and I look back nearly a century and consider the interest rate regimes the US has experienced. By comparing real interest rates and our own estimate of the neutral rate with their average values ​​over the past 90 years, we classify these regimes into high and low rate periods. When the interest rate is below the median, we classify the period as low rate and vice versa. Different interest rate regimes are a result of the type of economic shocks hitting the economy as well as the policy framework and stance.

Between 1934 and 1951 interest rates were low. The 3-month US Treasury bill rate, which tracks the benchmark US federal funds rate, averaged 0.5%. Thereafter, interest rates rose, peaking in the mid-1980s. Between the late 1950s and 2007, the average interest rate was high, at 5%. After the financial crisis, the US entered an era of low rates, with rates around 1%. More recently, interest rates have risen and we expect them to settle around a neutral rate of 3-3.5 percent.

To understand what these regimes have meant for investors historically, we look at 10-year returns using data from 1984 and divide the periods into high and low rate regimes.

In high-rate regimes, real returns 10 years ahead for global stocks and bonds were similar at just over 7% annually. But stock returns were four times more volatile than bond returns. Because bonds offered the same returns for lower risk (volatility), their performance relative to stocks was particularly attractive on a risk-adjusted basis.

By contrast, in low-rate regimes, real bond yields 10 years ago were around 4.5%, with global equities returning 8%. Stocks offered a sizeable premium over bonds. The volatility of stocks and bonds is similar across regimes, making bonds relatively less attractive on a risk-adjusted basis.

Given that we are currently in a high rate regime, what does this mean for investors today? The past is not prologue. Assuming no significant new economic or political shocks, Vanguard projects 10-year global equity returns of just over 5% and global bond returns of just under 5%. This forward-looking assessment resonates with history: in a high-rate regime, bonds offer more value in a portfolio.

Our projections embody the view that US equity valuations are stretched relative to fundamentals. The pain of rising interest rates has yet to be fully felt in global equity markets.

For a balanced investor who holds stocks and bonds in roughly equal parts, the higher interest rate environment and associated better outlook for bonds is good news. It means that bonds provide more value to the portfolio than before, not only in their typical role as a diversifier, but also as a source of return.

There is merit in holding certain bonds in any environment, especially in the current higher rate regime. Some investors may go further and tilt their portfolios towards bonds. This could better balance the greater certainty of better bond returns with the similarly less certain returns of stocks.

Everyone needs to be wary of investment risk and how much of it is included in the model’s projections. Our view is that interest rates will settle higher than pre-Covid and that US equity valuations are stretched. Our model’s history and projections suggest that in a high-rate regime, bonds provide greater value in a portfolio from both a return and diversification perspective. When regimes change, investors should at least reassess their portfolios.