Investors aiming to enhance their returns in the coming years might want to consider increasing their bond holdings, as suggested by Vanguard. The renowned asset manager is currently advocating a model portfolio that leans more heavily on fixed income, with an allocation of roughly 40% in equities and 60% in bonds. This is in contrast to a typical benchmark split that favors 60% equities and 40% bonds. Vanguard is particularly focusing on U.S. credit and long-term U.S. bonds, which indicates their confidence that higher bond yields can provide some protection against moderate interest rate hikes.
This bond-heavy approach is especially pertinent given the recent trend of the 10-year Treasury yield, which has seen an upward movement, even briefly surpassing the 4.8% mark last Tuesday. Meanwhile, traders are pulling back on their expectations regarding interest rate cuts from the Federal Reserve, keeping in mind that bond yields and prices move inversely.
Vanguard employs a strategy known as time-varying asset allocation, which is guided by their decade-long forecasts for returns. Senior investment strategist Todd Schlanger from Vanguard noted, “Based on our next decade’s outlook, it suggests that there’s a very low equity-risk premium.” The portfolio in question is effectively divided into 38% equities and 62% fixed income.
Delving into the portfolio, the model with a 40/60 split shows minimal allocation to large-cap growth stocks, which are presently trading at very high valuations. According to Schlanger, “Our research shows a relationship between stock valuations and their expected returns over the next ten years.” Given the current valuation levels, large-cap growth stocks may return anywhere from slightly negative to around 2% over the next decade.
Alternatively, Vanguard’s 40/60 portfolio favors value and small-cap stocks, and it also opts for equities in developed markets outside the United States. This preference is due to the significant growth observed in emerging-market stocks. On the fixed-income side, there’s a 22% commitment to U.S. investment-grade intermediate corporate bonds. “Our simulations generally show that corporate and credit bonds tend to outperform government bonds over a ten-year period,” Schlanger explained.
Approximately 6% of the fixed-income segment is invested in long-term U.S. Treasurys, with an average maturity of around 15 years. Duration plays a role here, as it measures a bond’s price sensitivity to interest rate changes, with longer maturities generally having higher duration. Schlanger remarked, “Even though there might be year-to-year volatility, most of our simulations indicate a term premium over ten-year periods, hence the strategy to extend the portfolio’s duration.” The term premium refers to the additional return investors seek for the heightened risk of holding longer-maturity bonds.
For those considering a more proactive investment strategy, Vanguard’s 40/60 approach might appeal. That said, Schlanger emphasized that there’s no pressing need for investors to completely overhaul their existing 60/40 portfolios. “Many people who stick with the classic 60/40 mix do so under the belief that returns are unpredictable, and maintaining a static allocation is wise,” Schlanger mentioned. “In fact, there’s a solid body of evidence supporting that strategy.”
The 40/60 model, however, is slightly more active. “Investors adopting this approach might achieve similar returns with reduced risk,” Schlanger suggested, targeting individuals willing to embrace a bit more risk in anticipation of better risk-adjusted returns over the next ten years.
