The prospect of bond yields remaining high for long should prompt a reversal of the typical 60/40 portfolio that holds 60 per cent in stocks and 40 per cent in bonds, U.S. bond giant asset manager PIMCO said on Tuesday.
In a five-year outlook report, PIMCO said the inflation shock of the early 2020s has caused a “generational reset higher in bond yields” that could offer equity-like returns to debt investors, with the added advantage of downside protection in case of an economic downturn.
“We believe this secular backdrop merits a rethinking – and even a reversal – of the traditional 60% stocks / 40% bonds asset allocation paradigm,” PIMCO said.
The 60/40 strategy counts on stocks rising amid economic optimism and bonds strengthening during turbulent times. But the negative correlation between the two asset classes has weakened over the past few years.
Stocks and bonds both sank in 2022 as the Federal Reserve began hiking interest rates, and rebounded in tandem last year.
With higher Treasury yields as a baseline, active investment managers can enhance returns in areas such as agency mortgage-backed securities without taking significant interest rate, credit, or liquidity risks, said the asset manager.
“A diversified bond allocation offers the potential for long-term equity-like returns with a more favorable risk-adjusted profile, especially given what may be stretched valuations in stock markets,” it said.
“Markets don’t appear to price significant recession risk, meaning bonds may be an inexpensive means to hedge that risk.”
PIMCO, which manages US$1.9-trillion in assets, said it sees attractive opportunities in U.S. asset-based lending, particularly in consumer-related areas. It expects debt investors to increasingly replace banks as direct lenders in areas such as mortgages and equipment finance.
Banks’ retrenchment from the commercial real estate sector will also present opportunities for investors, it said.
Risks to the five-year outlook include the rising U.S. government debt burden, which could put pressure on the value of long-term U.S. Treasuries. PIMCO said it has a “curve steepener as a structural trade,” meaning it expects longer-term debt to underperform shorter-dated securities.
It is also cautious on the artificial intelligence boom, which it said is reminiscent of past tech-driven boom-bust cycles, and warned about brewing risks in low-rated corporate debt vulnerable to a prolonged period of high borrowing costs.
“We are very concerned about the rapid growth within private, floating-rate markets that may not have been tested through prior default cycles,” it said.
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