A very common simple portfolio allocation used by many investors is 60% stocks 40% bonds. The most basic of these allocations would be 60% of a broad market index in stocks and 40% in a broad bond market index. This rationale is that stocks should produce volatile but positive long term returns and the bonds lower returns but less volatility.
This strategy has worked wonderfully over the last decade producing a total return of 93.6% with almost half the volatility of the S+P 500 which returned 125% . Note the extent to which the 60/40 portfolio limited losses and volatility during the huge stock market drop of 2008.
60/40 vs S+P 500 Jan 2 2008 to Jan. 2018
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| Total Return 60/40 portfolio (green) vs S+P 500 (blue) |
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| Total Return and Volatility 60/40 (Green) vs S+P 500 (blue) |
But that was during a period of a massive fall in interest rates engineered by the Federal Reserve with the additional headwind of traders who saw the market as a one way bet. It may not work as well going forward.
This period of "quantitative easing" was unique in the history of the Federal Reserve. Not only was it keeping short term rates low through its historical tool of the short term federal funds rate, it also purchased longer term securities in its policy of quantitative easing pushing down the rates of longer term bonds.
Policy has been reversed with five 1/4% rate increases since 2017 the most recent in December. WSJ reported that
Officials penciled in three quarter-point rate increases for next year, as they had in September, and two such increases each in 2019 and 2020
10 year chart Federal Funds rate showing the impact of the change in policy last year..reversing ten years of easing.
Long term chart Federal Funds rate
Here is a chart of the ten year Treasury bond for the past tens years which clearly shows the impact of quantitative easing and the Fed's"winding down"which began in 2017
Long term chart 10 year treasury bond yields
What does all of the above mean for your 60/40 allocation?
Watch the duration. Duration is related to but not the same as maturity. Duration is a measure of a bond prices sensitivity to changes in interest rates. The longer the duration the greater the movement in price. For instance a 1% change in interest rates means a 2% change in the price of a 2 year bond and a 10% change in the price of a 10 year bonds.
A simple way to change the allocation to shorter term bonds would be to swap the total bond index BND for BSV a mix of short term and long term corporate bonds.
The duration of BND the aggregate bond ETF is 7 years contains 40% Treasury Bonds 21% Mortgage backed securities and virtually the rest in corporate bonds
BSV an ETF that is a mix of short term corporate and Treasury bonds and corporate bonds with a duration of 2.8 Years
As interest rates have risen particularly since the beginning of the year the different impact on the two ETFs is clear:
graphs of returns BND blue BSV in Green
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| Total Return BSV vs, BND |
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| Total Return and Volatility BSV and BND |
Looking across categories a swap for vgit intermediate term treasury bonds which have a duration of for vgsh would cut duration from 7.6 t0 2 years
A swap from vcit intermediate term invest grade corporate bonds to vcsh would cut duration from 7.6 to 2.8 years
A swap from Jnk high yield bonds to sjnk short term high yield would cut duration from 6.5 to 2.1 years
Duration can be reduced even further by using a floating rate note ETF where the interest rate is reset much more frequently as the interest rate floats. For example:
FLOT a floating rate ETF has a duration of .13 years. It has had a +.4% return ytd
TFLO is a floating rate ETF tied to US Treasury securities with a duration of .01 years and a return of .25% ytd
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