Key points:
- A sizable shift in relative value has increased the appeal of adding fixed income’s predictable return stream to investment portfolios.
- Our scenario analysis indicates the forward return picture has become more favourable for bonds, and less favourable for equities, going forward.
- The role of equities as providers of a long-term growth in portfolios remains undiminished, but 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.
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, as the upper chart on the following page illustrates; this approaches the return targets of many balanced portfolios. For context, the chart 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 annualized 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.
Fixed income yields now approach the return targets of many financial plans
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
Relative value: how things have changed
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.
A sizeable shift in relative value
Equity earnings yield vs. bond yield to maturity (duration)
April 2013
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.
| Asset class | April 2013 | August 2023 | ||
|---|---|---|---|---|
| Value | Duration | Value | Duration | |
| U.S. T-bills | 0.1% | 1 to 3 months | 5.4% | 1 to 3 months |
| U.S. Treasury | 0.8% | 5.3 years | 4.4% | 6.2 years |
| U.S. Investment Grade | 2.6% | 7.1 years | 5.5% | 7.3 years |
| U.S. High Yield | 5.2% | 3.7 years | 8.3% | 4.0 years |
| S&P 500 | 7.2% | NA | 5.0% | NA |
August 2023
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.
Source - RBC Wealth Management, Bloomberg; data through 8/18/23
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.
Fixed income’s decade-long slump
Historical average yields and proportion of portfolio returns by asset class
Global balanced profile: returns contribution
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.
| Period | Fixed income and cash (average) | Equity (average) | Total (average) |
|---|---|---|---|
| 1990 to 2022 | 2.9% | 5.1% | 8.0% |
| 1993 to 2002 | 4.1% | 6.0% | 10.1% |
| 2003 to 2012 | 2.6% | 3.8% | 6.4% |
| 2013 to 2022 | 1.0% | 6.0% | 7.1% |
Global balanced profile: returns contribution as a percentage of total returns
| Period | Fixed income and cash (average) | Equity (average) |
|---|---|---|
| 1990 to 2022 | 37% | 63% |
| 1993 to 2002 | 40% | 60% |
| 2003 to 2012 | 41% | 59% |
| 2013 to 2022 | 15% | 85% |
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 left chart on the next page 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 chart below right. (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 U.S. Investment Grade 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.
Bonds are back
Yield comparison of equities vs. investment-grade corporate bonds
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 U.S. investment grade 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 U.S. investment-grade 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.
Source - RBC Wealth Management, Bloomberg; data through 8/18/23
Good omens for bonds
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.
A new rationale for fixed income
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.