Bonds are selling off as stocks tumble. Here’s what it means for 60/40 portfolios

Published Thu, Oct 5 20231:40 PM EDTUpdated Thu, Oct 5 20233:31 PM EDT

The balanced portfolio — an allocation that's split 60% toward equities and 40% in bonds — suffered in this week's market tumult, but investors should think twice before they abandon the model. Earlier this week, investors' fears of the Federal Reserve's higher-for-longer rate policy shook up both the fixed income and equity markets. The 10-year Treasury yield shot up to levels not seen since 2007, raising concern that the benchmark rate could soon touch 5% . The action in the fixed income market also helped send stocks reeling, with the Dow Jones Industrial Average tumbling more than 400 points Tuesday. The 60/40 portfolio wasn't spared, either: The iShares Core Growth Allocation ETF (AOR) , which has a 60/40 split, is facing declines from both asset classes. It's down about 1.6% this week. AOR YTD line AOR's performance year to date The slump harkened back to 2022, when equities fell alongside bonds. While the 60/40 blend is designed to offer diversification and blunt the effect of price volatility, the AOR ETF dropped 15.6% amid last year's havoc. "They're not supposed to go down at the same time, and that's tough," said Blair duQuesnay, a certified financial planner and investment advisor at Ritholtz Wealth Management. "But we have to look forward as investors, and the long-term asset allocation I would recommend today is the same as it was three years ago," she said. A model under pressure While a combination of high inflation and sharp increases in interest rates was the culprit behind the sharp declines in bond prices last year, the disturbance going on lately seems to be related to questions surrounding the Fed's future policy, according to Roger Aliaga-Diaz, global head of portfolio construction at Vanguard. "We don't see rates going back to the pre-Covid levels," he said. "The neutral policy rate is now higher on a permanent basis, perhaps 3.5% or 4%, and that gives you a higher floor for the 10-year bond, compared to previous years." He noted that this adjustment to higher rates is painful on the front end for investors, but ultimately the situation will improve going forward as policy normalizes. "The central bank's rates are an anchoring point for the 10-year," Aliaga-Diaz said. "That anchor moved from zero to 5, but the central bank won't be going from 5 to 10." "Once you settle at this higher level of rates, there's no reason why the correlations shouldn't go back to normal," he added. For investors, the pain of the price decline now in fixed income can overshadow the eventual income opportunity from higher yields over the longer term. "[I]nvestors still hate bonds at these levels — rates we would've dreamed of two years ago," said duQuesnay. "That's pretty shocking. It should be easier to allocate to bonds when you can get close to 5% on the 10-year." Evaluating next steps Rather than selling out of bonds as prices fall, investors may want to think about where they stand with respect to duration. "Waiting until the Fed starts cutting rates to add duration is too late," duQuesnay said. "You're not going to get the benefit of a rally in bonds if you sit really short in duration." Duration is a measurement of a bond's price sensitivity to changes in interest rates. Bonds with longer maturities tend to have greater duration. DuQuesnay said she's going from less than a year to three years in average duration with high credit quality corporate bonds, as well as Treasurys and agency bonds. "Rather than having risky corporate debt, we'd rather take risk in stocks," she said. "Boring is lovely." Vanguard's Aliaga-Diaz noted that the 60/40 portfolio will average 6% on a 10-year forward-looking basis, so there are bound to be tumultuous times and periods of strong performance. "It's a reminder that this is really challenging for the 60/40. … You don't get this 6% every year, you get an average." However, just as 2022 put the model under pressure, investors could still use this latest rout as a gut check. "Make sure to realize the extreme scenarios you can face," said Aliaga-Diaz. "Is this an opportunity to move to a risk profile that you're more comfortable with?" Finally, look for opportunities as other investors head for the hills. Tax-loss harvesting is a way to trim down losing positions in your portfolio to offset gains and lower your tax bill. Redeploy the proceeds into other assets that still meet your long-term goals but be sure to avoid violating the wash sale rule. In other words, do not buy an asset that's substantially identical to the one you just dumped within 30 days before or after the sale. "That's something people should consider if they had losses, especially in fixed income," said Joe Kalish, chief global macro strategist for Ned Davis Research. "That's something you should consider if you're in that situation. Discuss it with your tax professional."