The U.S. bond market is headed for its worst year of returns on record, but that could mean better days ahead for patient investors.
High inflation, coupled with the Federal Reserve's response to raise interest rates, led to the historic sell-off. And while the Fed suggests it'll likely continue raising rates through 2023, the worst may be over for the bond market. With much higher nominal yields versus a year ago, it'll take a much bigger move than anticipated to set bonds reeling downward again. That's not to say it couldn't happen, but the expected long-term return for bonds has climbed significantly since 2021.
With that in mind, investors may be wondering if they should shift their retirement portfolio asset allocation to take advantage of today's higher bond yields.
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Doing better than 60/40?
The standard retirement portfolio advice has been to put 60% of your investible capital in stocks and the other 40% in bonds. But that might not be optimal for everyone, especially in today's environment.
A 30/70 portfolio may support the same level of portfolio withdrawals over 30 years as a 60/40 portfolio, according to research from Morningstar. The researchers found that retirees can safely withdraw 3.8% of their initial portfolio balance every year for 30 years, adjusting for inflation, with a 90% success rate for any equity exposure between 30% and 60%. The results are based on their expected returns and the variance in those returns for equities and bonds.
Part of the reason researchers see good results from a bond-heavy portfolio is because the expected returns for bonds have climbed to nearly 5%. That's up from less than 3% last year. Meanwhile, the expected returns for equities has increased as well, from about 8% to 10%.
While the percentage point change in expectations is nearly the same, the relative change is vastly higher for bonds. What's more, bonds produce lower volatility in their returns, reducing the impact of sequence of return risk, the risk that poor returns early in retirement will lead to financial ruin.
As a result, some retirees may do better with a heavier weighting toward bonds than they may have in the past.
Who can get the most from bonds?
The benefit of holding bonds is that they offer more stable returns than stocks and typically provide a ballast to the returns provided by equities. Still, the long-term expected return for bonds sits well below the expected returns for stocks.
As such, investors with shorter time horizons can benefit more from bonds, which can provide more stable portfolio values.
In fact, Morningstar researchers suggest a retiree with a 10-year time horizon could maximize their safe withdrawal rate with a portfolio consisting of 90% bonds and just 10% equities. They could withdraw 9.7% of their portfolio per year (adjusting for inflation) with a 90% success rate. A portfolio with more than 30% of equities is actually detrimental to their safe withdrawal rate, according to the researchers.
As a retiree's time horizon elongates, it makes sense to take greater exposure to stocks. Still, someone with a 40-year time horizon could use the same withdrawal rate for a portfolio consisting of anywhere between 40% and 70% equities and see a similar success rate of about 90%.
Investors with longer time horizons may, however, benefit from higher terminal portfolio values when they increase exposure to stocks. In other words, long-term investors can take a similar amount of risk but gain greater upside if they stick with higher equity exposures.
All this means that retirees who prefer to play it safe may do well to increase their exposure to bonds.
