The Reach For Yield...And Its Consequences

  • Yields on long-term Treasury bonds have ticked up from their record July lows, but the bond market still managed to make history last month as junk bond yields fell to an all-time low of 6.73% on August 30th. (Yields near the 7% level have typically spelled trouble for the junk market.)
  • Maybe we’ve forgotten the economic law of scarcity, but we remain struck that investor infatuation with portfolio income is higher than ever (read any recent issue of Barron’s), just as there’s less of it available than any time in history.

The chart on the following page shows that the total yield on a conventional 60/40 balanced portfolio fell below 2% for the first time ever in July and remains there today (August 31st portfolio yield = 1.98%). This is less than half of this portfolio’s median (1878-to-date) yield of 4.16%.

As Paul Macrae Montgomery (Universal Economics newsletter) points out, yields are not just another market indicator but a component of one’s return as well. In the case of the 60/40 portfolio, the combined yield provided by stock dividends and Treasury coupons has contributed more than half of the portfolio’s 7.75% annualized return since 1878. What do today’s low yields say, then, about prospective returns on the 60/40 portfolio?

Does the total yield on a balanced portfolio (in this case, the tradi- tional 60/40 mix) give us any insight into the probable future gains from that portfolio? Unfortunately, yes.

The chart below overlays the 60/40 portfolio yield with the 10-year forward return for the portfolio. (This is analogous to many studies we’ve presented on the predictive ability of stock market valuation measures.) There’s a stunning correlation of 0.66 between the two series back to 1878, which is an exceptionally tight correlation, on par with the best of our equity-only valuation tools (i.e., Normalized P/E, Price/Cash Flow, etc.).

It’s no coincidence that the best 10-year returns for the 60/40 portfolio occurred after the portfolio’s total yield peaked out above 9% in 1981 and 1982. Despite the huge gains in stock and bond prices off their early 1980’s lows, note the beginning portfolio yield still comprised more than half of the 60/40 portfolio’s 17% annualized return over the subse- quent ten years. Yield matters—even in a major bull market.

Portfolio yield is far from a 19 perfect predictor of long-term portfolio returns. For example, the 60/40 portfolio yield dropped to the then-record low below 3% in 1945-46, but subsequent 10-year portfolio returns still reached a fairly healthy +10% annualized. Then again, equity valuations were very depressed at the beginning of that period. The same cannot be said of today. Based on current portfolio yields, the 10-year future return to a passively managed, 60/40 portfolio is, unfortunately, likely to be even lower than the past ten years’ annualized return of +6.9%. Strategies emphasizing flexible asset allocation and fairly concentrated equity bets stand the best chance of outperforming in this otherwise underwhelming world.

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