But if we look at bonds in countries like Japan, Germany, France, and Switzerland, where yields were already at or below zero, we see that yields today are higher than they were at points in 2019.
Yields going higher should be a function of revised inflation and growth expectations, factors which have not been present in those countries this year to any greater extent than they have in the UK or US.
That tells us that we may have found the lower bound—the point at which bond yields struggle to go lower. And if bond yields can not go down, then bond prices can not go up, and if bond prices can not go up, bonds will not be able to counterbalance stocks as they have recently.
That presents a risk to the 60/40 portfolio, which could experience deeper drawdowns and higher volatility as a result.
Land of no return
Low bond yields are not just a problem for the risk profile of the 60/40 strategy. They also impact potential returns. On the “40” side, this is obvious. If global government bonds yield 0.6 per cent today, that is the return investors should expect.
Even if nothing changes, even if interest rates and yields remain at their current record-low levels, those bonds will deliver a return of just 0.6 per cent per annum.
On the “60” side, understanding the impact of bond yields takes a bit more work, and it is easy to get lost in the jargon of discount rates and opportunity costs.
What it all comes down to is patience. Companies can take a long time to grow their profits and deliver cash back to shareholders.
Are investors willing to wait? If a safe bond yields 5 per cent or 6 per cent, investors might prefer to collect those safe coupons rather than waiting a long time for uncertain profits.
But if the yield on a safe bond is near zero—why not wait? If safe bonds offer meagre returns, investors may be much more patient, and much more willing to pay up for the distant potential profits on offer in equity markets..
In this way, lower bond yields lead to higher valuations for equities. That is exactly what we have seen this year. On a simple price-earnings ratio, equity markets are more expensive now than they were at the start of the year, but because yields on US Treasuries have fallen, stocks look no less attractive relative to bonds. This suggests that falling bond yields were a—maybe the—key driver behind the stock markets' remarkable returns this year.
