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  4. Rethinking the 60:40 portfolio

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Rethinking the 60:40 portfolio

   

Government bonds used to provide both an income and the prospect of strong positive returns during a recession. Balancing equity exposure with significant government bond exposure therefore became a core tenet of portfolio construction. But today, with such low starting yields, government bonds offer little income or upside potential, forcing investors to rethink their approach to both diversification and income generation. 

In the next decade, a traditional UK market 60:40 stock-bond allocation is expected to earn only around 4% a year (2021 LTCMA estimate). But many investors require higher yields and higher returns than that from their portfolios.
 

Seeking higher income

Exhibit 1 shows a range of fixed income asset classes offering income and their correlation with global equities. While higher yields are available to investors prepared to look beyond developed market government bonds, the challenge is building a fixed income portfolio with sufficient yield without uncomfortably increasing the correlation with equities.

Exhibit 1: Investors will need to look across the piste to get the best balance of yield and risk
Fixed income yields
%

Source: Bloomberg, Bloomberg Barclays, ICE BofA, J.P. Morgan Economic Research, Refinitiv Datastream, J.P. Morgan Asset Management. Beta to MSCI World is calculated using monthly total returns since 2008. Indices used are as follows: Euro IG: Bloomberg Barclays Euro-Aggregate – Corporate; Global IG: Bloomberg Barclays Global Aggregate – Corporate; UK IG: Bloomberg Barclays Sterling Aggregate – Corporate; US IG: Bloomberg Barclays US Aggregate – Corporate; Euro HY: ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index; Global HY: ICE BofA Global High Yield Index; US HY: ICE BofA US High Yield Constrained Index; EMD Corporate: CEMBI Broad Diversified; EMD local: GBI-EM Global Diversified: EMD local – China: GBI-EM China: EMD Sovereign: EMBI Global Diversified; EMD Sov. IG: EMBI Global Diversified IG; EMD Sov. HY: EMBI Global Diversified HY. Data as of 17 November 2020.

Investors may be comfortable shifting a higher proportion of their fixed income allocation towards credit, on the assumption that any downside will be capped by central bank intervention. However, we caution against abandoning a focus on fundamentals. Given the ongoing near-term uncertainties, investors making their first steps out of government bonds into the credit markets may benefit from focusing on the highest-quality segments. We are also mindful that the dependence on central bank support gives rise to risks of taper tantrum-style events of the type seen in 2013.   

Chinese government bonds offer one potential solution, with a 2-3% yield depending on duration, next to no correlation with global equities and the potential for long-term currency appreciation. Flexible fixed income strategies with an absolute return objective could also help.

Outside of fixed income, real assets such as real estate and particularly infrastructure can offer more attractive yields in return for low liquidity. While real estate has clearly come under pressure because of Covid, we don’t believe people will be working from home forever, given that one of the key benefits of offices – having everyone in the same place at the same time – cannot easily be replaced. Given office floor space requirement is driven by peak demand, say on a Monday, post-pandemic demand may prove more robust than some fear. Nor will all shopping be done online; however, just as the rise in online shopping creates a challenge for some retail properties, it also creates an opportunity in warehouses.

Core infrastructure has demonstrated remarkably consistent and defensive income streams both during this recession and during the last financial crisis. Given yields close to 7% and the ability to access reliable contracted or regulated cash flows with the potential for capital upside and inflation protection, infrastructure could play an increasingly important part in investor portfolios for those who can access it and are comfortable with the lack of underlying liquidity.
 

Seeking diversification

While adding higher yielding credit, real estate and infrastructure to a portfolio can help replace some of the income that government bonds used to offer, while still providing some diversification from equities, investors may need to look elsewhere for the kind of downside protection traditionally offered by government bonds.

Of the hedge fund strategies available, macro funds have historically done the best job of consistently protecting portfolios during equity bear markets. While return expectations for macro funds as a whole are relatively low, good manager selection may help to boost returns during bull markets while still providing downside protection during bear markets (Exhibit 2).

Exhibit 2: Macro funds have tended to provide downside protection
Hedge fund style returns during bear markets
% total return

Source: Hedge Fund Research Indices (HFRI), Refinitiv Datastream, J.P. Morgan Asset Management. 2000 bear market is from 31 March 2000 to 31 October 2002, 2008 bear market is from 31 October 2007 to 28 February 2009, 2020 bear market is from 31 January 2020 to 30 April 2020. Hedge fund strategies are defined in the HFRI hedge fund strategy classification system. Data as of 17 November 2020.

In summary, while government bonds can still provide some diversification, they offer much less income and upside potential than they used to and are vulnerable to a potential pickup in inflation and/ or growth. By adding real estate, infrastructure and macro strategies to portfolios, investors may be able to increase both their risk-adjusted income and returns relative to a traditional stock and bond portfolio (Exhibit 3).

Exhibit 3: Adding alternatives may help improve the risk/ return profile of a portfolio
Expected returns and volatility for a GBP investor in coming 10-15 years
% annual compound return

Source: Long-Term Capital Market Assumptions, J.P. Morgan Asset Management Multi-Asset Solutions. Expected returns and volatility assumptions refer to the next 10-15 years. Forecasts are not a reliable indicator of current and future results. Data as of 31 October 2020.

More key themes for 2021

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Download the full outlook

Past performance and forecasts are not reliable indicators of current and future results.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not a reliable indicator of current and future results.
 

J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. To the extent permitted by applicable law, we may record telephone calls and monitor electronic communications to comply with our legal and regulatory obligations and internal policies. Personal data will be collected, stored and processed by J.P. Morgan Asset Management in accordance with our EMEA Privacy Policy www.jpmorgan.com/emea-privacy-policy.
 

This communication is issued in the UK by JPMorgan Asset Management (UK) Limited, which is authorised and regulated by the Financial Conduct Authority. Registered in England No. 01161446. Registered address: 25 Bank Street, Canary Wharf, London E14 5JP.

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