The current Goldilocks-like scenario, with interest rates falling and a recession still avoidable, is good news for balanced portfolios.Nuthawut Somsuk/iStockPhoto / Getty Images
The U.S. Federal Reserve Board’s move to slash its policy rate by a hefty half a percentage point on Sept. 18 awakened many investors to the prospect that the fat bond yields that accompanied high inflation are thinning now that consumer price growth is firmly on a downtrend.
For many, there’s renewed focus on fixed-income allocations beyond simply snapping up guaranteed investment certificates or parking assets in high-interest savings accounts.
“This is the conversation we’re having with our clients every day right now. It’s all we’re talking about, it seems,” says Kristin Mcintosh, senior wealth advisor and portfolio manager with Legatum Wealth Advisor at National Bank Financial Wealth Management in Calgary.
“We are getting real yields beating inflation, generating a real return with essentially no risk,” she says. “At the same time, the equities backdrop remains constructive.”
With yields across the curve outpacing the consumer price index, bonds reassuming their historical defensive hedge to equities, and relatively resilient earnings from stocks, investors find themselves in almost the inverse environment of 2022 – the worst stretch for both stocks and bonds since 1974.
The current Goldilocks-like scenario is a recipe for success for balanced portfolios invested in a mix of 60 per cent stocks and 40 per cent bonds. Although the exact allocations of the balanced portfolio aren’t set in stone, general adherence to such a mix is intended to deliver the steadiest performance with the least choppiness, according to modern portfolio theory.
And during the past couple of decades, it has delivered. Between January 2001 and August 2024, a 60-40 portfolio generated a total return of 254 per cent based on weighted exposures to the S&P 500 index and the Bloomberg U.S. Aggregate Bond Index, according to Bloomberg LP data. Returns were positive for two-thirds of the 283 months during that period.
“That’s why, historically, many people have opted for the 60-40 solution. It will deliver,” says Andrew Pyle, senior advisor and portfolio manager with Pyle Wealth Advisory at CIBC Wood Gundy in Peterborough, Ont. “It may not deliver a better return than your neighbour next door who is flooded with equities, but on a risk-adjusted basis, [it’s] probably a better return, overall, and a more comfortable experience.”
Going longer on bonds
While equities have posted strong returns in the U.S. and Canada this year, bonds on both sides of the border are the bigger draw now in balanced portfolios.
Ms. Mcintosh says her office has gone “heavier” on fixed income as a percentage of the overall asset mix (to approximately 45 per cent), laddering clients into Canadian bonds dated through 2030. Roughly two-thirds of that is in investment-grade corporate credit.
“If you continue out to 2029 and 2030, we’re comfortably above the 4 per cent range in overall yield to maturity,” she says. “Over the next couple of years, given the Bank of Canada is likely to reduce [its key interest rate] another percentage point and a half, these rates are going to look great for the client, and again with very little associated risk.”
While the yield pickup in corporate notes is appealing, Mr. Pyle prefers a heavier weighting toward lower-risk government securities as the Canadian and U.S. economies soften.
“Most people would agree that, based on the latest employment figures, these are not vibrantly strong economies anymore,” he says. “In that environment, when interest rates are coming down, government securities are a good place to be.”
The yield curve is becoming sloped positively toward the long end as the bond market prices in an economic soft landing and short-term interest rates fall in line with central bank policy expectations that Canadian and U.S. overnight rates will be cut by between 150 and 200 basis points before landing at a “neutral” level.
“It makes sense to start to look at duration for a couple of reasons,” Mr. Pyle says. “One, in a declining rate environment, longer-term bonds will tend to perform better than shorter-date bonds. The other thing is, for investors who exited bond or stock markets entirely [in 2022 and 2023] in favour of GICs or very, very short-term vehicles such as high interest savings accounts, interest rates are coming down. They’re now exposed to reinvestment risk.”
For example, Canadian and U.S. T-bill yields that were north of 5 per cent at the beginning of the year have fallen well more than 100 basis points, a trend that should continue as both the BoC and Fed cut policy rates through early 2025. In addition, many longer-dated bonds are trading below par, leaving room for tax-efficient capital appreciation.
“Extending duration in the portfolio allows us to minimize that reinvestment risk and capture a higher overall return coming from both yield and price,” Mr. Pyle says.
What about equities?
Shelley Smith, senior advisor with TD Wealth Private Investment Advice in Toronto, says that with inflation under control, policy rates declining and an economic backdrop that appears strong enough to avoid recession, she expects equities should remain broadly supported. Falling interest rates tend to benefit rate-sensitive sectors such as financials, utilities and real estate income trusts.
“The ‘60’ side of the portfolio is going to do well for investors over the next 12 months as long as we continue to see earnings growth, lower inflation numbers and those falling interest rates,” she says. “But if we do head into a recession, that’s where clients are going to see that ‘40’ side do well by offering a bit of a hedge and downside protection.”
Ms. Mcintosh agrees that bonds should go up if equities fall in the case of a recession.
“[But] if we don’t see [a recession], and we get a true soft landing, then even if equities are stagnant, those returns on stocks such as big dividend payers are going to pair nicely against these strong bond yields,” she says.
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