With bond yields near or above the return targets in many financial plans, we think fixed income should play a bigger role in portfolios.
September 6, 2023
By Mikhial Pasic, CFA and Joseph Wu, CFA
Returns from the fixed income component of balanced portfolios (which include allocations to both stocks and bonds) have been unusually low over the past decade as central banks used multiple policy tools to repeatedly suppress bond yields. Market conditions have changed. Bond yields have more than doubled over the past three years, making the risk-reward tradeoff between fixed income returns and equity returns much less one-sided. Thus, we think the rationale for keeping portfolio commitments to fixed income below the long-term targeted exposure – an investment stance that has prevailed for more than a decade – is no longer persuasive.
We believe fixed income should take on a more prominent role in a balanced portfolio going forward because the yields available today approach, and in some cases exceed, the return targets in many financial plans. The return on a basket of bonds equally weighted between governments, investment-grade corporates, and high-yield bonds has risen above six percent for the first time in more than a decade; this approaches the return targets of many balanced portfolios. For context, the chart below compares the bond return to the long-term return target of the California Public Employees Retirement System (CalPERS), the largest U.S. pension fund. Moreover, the return from this all-fixed-income mix currently trails the 7.6 percent annualised return from a hypothetical balanced portfolio (55 percent stocks, 43 percent bonds, and two percent cash) since 1990 by the slimmest margin in nearly 20 years.
Line chart showing the yield on a diversified fixed income position dating back to the year 2000 and the return target for a typical balanced portfolio. Since 2000, there have been three periods when diversified fixed income could have met the return requirements: in the early 2000s, during the financial crisis, and in 2023.
Fixed income returns are represented by an equally weighted combination of the Bloomberg US Treasury Bond Index, Bloomberg US Aggregate Corporate Bond Index, and Bloomberg US Corporate High Yield Bond Index; calculations are based on yield to worst. CalPERS target is based on the reported discount rate.
Source – RBC Wealth Management, Bloomberg; data through 8/18/23
There was a sizable shift toward equities in the era when bond yields spent years significantly below the targeted returns of most investors. During this period, bond investors found themselves forced to lock in low returns for extended periods. This pushed many investors to boost their allocations to equities, which in the years following the financial crisis often provided going-in dividend yields that were higher than 10-year bond yields, along with the prospect for future dividend increases and capital growth. Some investors actively reallocated proceeds from maturing bonds into equities, while others allowed equity exposure to drift higher by opting not to periodically rebalance the gains delivered by strong stock markets back into bonds.
A decade ago in 2013, investors could expect a higher return for each outward push on the risk curve, as the charts below illustrate.
Two bar charts highlighting the compensation that investors were granted for accepting equity risk over fixed income risk in April 2013 and August 2023. In 2013, investors were compensated at a higher rate for owning equities instead of bonds, which meant that equities had a higher return potential. In 2023, investors do not earn a meaningful premium in equities over bonds to compensate for the risk that is associated with owning equities.
Fixed income yields are represented by the Bloomberg US 1–3 Month Treasury Bill Index (U.S. T-bills), Bloomberg US Treasury Bond Index (U.S. Treasury), Bloomberg US Aggregate Corporate Bond Index (U.S. IG), and Bloomberg US Corporate High Yield Bond Index (U.S. HY); calculations are based on yield to worst. S&P 500 earnings are based on 12-month forward estimates.
A move from short-term government T-bills to longer-term government bonds entailed a substantial pick-up in yield, as did a move from government bonds to investment-grade corporate bonds. Additional expected return was also available for investors willing to push farther out on this continuum, to areas such as high-yield bonds or, ultimately, equities. This setup has flattened out greatly in 2023, and risk premiums have compressed.
Investors were rewarded for acting on the relative value setup in 2013, as equities contributed the lion’s share of returns to balanced portfolios over the decade that followed. A 43 percent allocation to fixed income (RBC Wealth Management Canada’s Strategic Asset Allocation target weight) only contributed about 15 percent of the total returns earned from 2013 to 2022, well below the roughly 40 percent average contribution that fixed income had delivered in prior decades, as the charts below show.
There are two bar charts which show the excess return and contribution to returns between bonds and equities over the last three decades. In the periods between 1990 to 2012, bonds were able to generate returns in the range of 2.6% to 4.1% and equities were able to generate average returns of 3.8% to 6.0%. Due to ultra-loose monetary policy and stable inflation from 2013 to 2022, bonds only generated an average annualized return of 1.0% over the decade, whereas equities returned an average annualized return of 6.0%. The second chart also reflects this from the perspective of contribution to portfolio returns. Over the period between 1990 and 2012, bonds accounted for roughly 40% of the returns of a global balanced portfolio; whereas in the period from 2013 to 2022, bond’s contribution of returns fell meaningfully to an average of 15% of a global balanced portfolio.
RBC Wealth Management Canada’s Global Balanced Profile asset mix consists of 20% S&P/TSX Composite, 20% S&P 500 Index, 10% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 4.5% FTSE Canada Short Government Bond Index, 4.5% FTSE Canada Mid Government Bond Index, 6.5% FTSE Canada Short Corporate Bond Index, 6.5% FTSE Canada Mid Corporate Bond Index, 10% Bloomberg Global Aggregate Bond Index CAD Hedged, 3% S&P/TSX Preferred Share Index, 4% Bloomberg U.S. Aggregate Credit Corporate High Yield Index CAD Hedged, 4% J.P. Morgan EMBI Global Core Index CAD Hedged, and 2% FTSE 30-Day T-Bill Index.
Source – RBC Wealth Management, Bloomberg; data through 8/24/23
With the significant increase in bond yields over the past three years, the incremental reward for shifting allocations toward riskier assets has greatly diminished. Whereas a sizable shift out along the risk curve into equities was required in order to have a chance of achieving required portfolio returns back in 2013, the picture looks radically different today. Higher interest rates have restored the income advantage, especially for corporate bonds versus equities. As the first chart below illustrates, U.S. investment-grade bonds currently have a yield advantage of approximately 400 basis points (bps) over the S&P 500 dividend yield. The gap is narrower when bond yields are compared to a higher-dividend equity index, but the relative trend is consistent with what the chart depicts.
Simply looking at the dividend yield on the equity market only accounts for a portion of the return for equity investors because shareholders have a claim on the entire earnings stream, not just what is paid out in dividends. A better comparison looks at the earnings yield of stocks versus bond yields, as shown in the second chart below. (Earnings yield is calculated by dividing the earnings per share of a stock or index by the market price. This is the inverse of the price-to-earnings multiple; a stock trading at 20x earnings has an earnings yield of five percent.) The yield on the broad Bloomberg US Aggregate Corporate Bond Index is currently 50 bps greater than the earnings yield on the S&P 500 Index. This stands in stark contrast to the recent history of this relationship: from 2010 to 2020, the earnings yield of equities exceeded that of corporate bonds by roughly 300 bps, with the spread sometimes widening beyond 400 bps in 2012 and 2013.
Two line charts that reinforce the relative value proposition that currently exists in fixed income. The first chart illustrates the equity dividend yield of the S&P 500 and the yield of the Bloomberg US Aggregate Corporate Bond Index. The yields converged in 2020 and have since diverged meaningfully, with bond yields rising much higher than equity dividend yields. The second chart shows both the S&P 500’s forward earnings yield and the yield on the Bloomberg US Aggregate Corporate Bond Index. Both have converged in the 5% to 6% range since 2022.
Investment-grade bond yield is represented by the Bloomberg US Aggregate Corporate Bond Index yield to worst. S&P 500 dividend yield is based on trailing 12-month dividends paid; earnings yield is based on 12-month forward estimate.
Historically, periods between the final interest rate increase in a U.S. rate hiking cycle and the Federal Reserve’s first rate cut have seen bonds perform well relative to equities. While forecasting future central bank actions is always difficult, we think it is likely that we are nearing this point, given the magnitude of rate hikes that have already occurred and the fact that several leading economic indicators suggest the economic cycle is approaching its later stages.
What’s more, given the shift in valuations over the past decade, our scenario analysis on forward returns has become more favourable for bonds and less favourable for equities. Yield-at-time-of-purchase has been highly correlated with the long-term returns generated by bonds over a century that featured constantly changing economic, monetary, inflation, and geopolitical conditions. Thus, in our view, history strongly suggests the higher starting yields on bonds today – more than double those available just three years ago – translate into a much improved return outlook for fixed income over the coming decade at least. By comparison, the higher starting multiple on stocks (or the lower earnings yield, as this is the inverse of the multiple) suggests a somewhat less favourable setup for equities going forward, absent robust growth in corporate earnings.
This article presents a broad view of the entire fixed income asset class. It should not be construed as a call to extend duration within fixed income portfolios, or to add credit risk; rather, it is an observation that the recent large increase in base rates affords investors an opportunity to take advantage of significantly higher available yields across the fixed income market. The role of equities in portfolios as providers of a long-term, growing income stream and a commensurate increase in capital values remains undiminished. But in our view, the rationale for keeping portfolio allocations to fixed income below the long-term targeted exposure that has prevailed for more than a decade is no longer persuasive.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.