Investors looking to boost returns in the coming years may want to consider upping their bond allocations, according to Vanguard. The asset manager has a model portfolio that’s overweight on fixed income, reflecting a roughly 40% allocation toward equities and 60% in bonds. In particular, it’s overweight on U.S. credit and U.S. long-term bonds compared to a benchmark that’s split 60% toward equities and 40% in fixed income. This reflects Vanguard’s belief that higher bond yields can offer some cushion against modest increases in rates. This skew toward bonds is especially important as the 10-year Treasury yield has been on an uptrend as of late, briefly topping the 4.8% level on Tuesday. Traders have been dialing back their expectations for interest rate cuts from the Federal Reserve. Bond yields and prices move in opposite directions. The portfolio uses a method called time-varying asset allocation, which is based on the asset manager’s 10-year forecasts for returns. “Based on our expectations for the next decade, it would imply that there’s a very low equity-risk premium,” said Vanguard senior investment strategist Todd Schlanger. The exact portfolio breaks down to 38% in stocks and 62% in fixed income. Breaking down the portfolio The model 40/60 portfolio doesn’t have a big allocation toward large-cap growth stocks , which have reached very high valuations, Schlanger said. “There’s a relationship that we found through our research between the valuations of stocks and their decade-ahead future returns,” he said. The valuation of large-cap growth stocks implies somewhere between slightly negative to 2% returns over the next decade, according to the research, he added. Instead, Vanguard’s 40/60 portfolio leans into value and small-cap stocks. In addition, it allocates to equities in developed markets, excluding the United States, preferring them over emerging-market stocks because there has been a strong run up in the latter asset class, Schlanger said. The fixed-income portion has a 22% allocation in U.S. investment-grade intermediate corporate bonds . “In most of our simulations, corporate bonds, credit bonds end up outperforming government bonds over a 10-year period,” Schlanger said. Roughly 6% of the fixed income sleeve is in long-term U.S. Treasurys, with duration around 15 years. Duration is a measure of a bond’s price sensitivity to fluctuations in interest rates. Bonds with longer maturities tend to have greater duration. “You can have volatility year to year, but in most of our simulations over decadelong periods, you see a premium — what’s called a term premium — for investing in longer-dated bonds,” he explained. “Therefore, the model is preferring to lengthen the duration of the portfolio.” Term premium refers to the excess reward that investors demand over time for the risk of holding longer-dated bonds. A more active approach Investors don’t have to necessarily ditch their 60/40 portfolio, Schlanger said. Vanguard’s 40/60 portfolio is just one of 13 different strategies the firm offers. “Somebody investing in, let’s say, the classic 60/40 — they would believe that returns are really not predictable and it’s best to just hold a static mix,” Schlanger said. “Certainly there’s a lot of evidence to suggest that that is a great way of investing.” The 40/60 strategy is a bit of a more active approach, he said. “In doing so, they could aim to achieve a similar level of return with less risk,” he said. “So that’s really who it’s aimed at — somebody with maybe a little bit more of a risk tolerance and for taking that risk, they expect to be compensated with a better risk-adjusted return over the next decade.”
