The 60-40 Portfolio is On Its Last Legs

By John Banks

The 60-40 portfolio has been a cornerstone of retirement strategy for decades.

Around the United States and the world, hundreds of millions of retirees have had, or still have currently, some version of a 60-40 portfolio. 

For American retirees, though, a serious problem looms. The 60-40 portfolio is on its last legs. It is simply going to stop working as intended, for reasons that are impossible to stop.

When investors fully realize what has happened — a process that will not happen all at once, but over time — financial advisers will be forced to give up the 60-40 portfolio as a core plank of retirement strategy. It will go the way of the dodo.

To briefly recap the concept, the 60-40 portfolio is built around a simple idea: A portfolio that contains a mix of stocks and bonds, preferably U.S. Treasury bonds, is safer and more desirable than a portfolio of stocks alone.

The “60-40” part comes from the usual mix of 60% stocks and 40% bonds. The numbers can be adjusted while maintaining the same concept. A 70-30 portfolio would be more aggressively tilted towards stocks, for example, whereas a 50-50 portfolio would be more conservatively tilted toward bonds.

The 60-40 portfolio concept has been wildly popular, and overall successful, due to a behavioral aspect of U.S. Treasury bond performance in declining markets.

To give a simplified version of how it works, when stocks broadly decline in value, U.S. Treasuries tend to rise in value. This happens because Treasuries are seen as a “safe haven” and a place to park capital when the world looks dangerous or stocks look unattractive, and also because Treasury bond prices rise as interest rates fall.

The fact that Treasury bond prices rise as interest rates fall — which is a mechanical relationship, not a correlation — is key to the 60-40 portfolio’s success.

When the economic outlook is grim, the Federal Reserve tends to cut interest rates. These interest rate cuts tend to boost the price of bonds (via the mechanical relationship between falling rates and rising bond prices) at the same time stocks are going down.

What this means is that, when times are good, the 60-40 portfolio gives the saver capital appreciation on the equity side and modest yield income on the bond side.

And then, when times are bad, a decline in the value of equities is offset by a rise in the price of U.S. Treasuries (which tend to rise in value as stocks fall, because of safe haven flows and falling interest rate yields as earlier described). 

Overall, then, the 60-40 portfolio gives the saver downside portfolio protection that doesn’t cost anything, and even provides a bit of positive income (via yield income) when things are going well. It’s like an insurance policy that pays a modest premium every year, rather than costing money to maintain.

But the 60-40 portfolio will be going away for a simple, inevitable reason: The U.S. Treasuries market is broken, and it will likely stay broken for years to come.

The U.S. Treasuries market is broken in two ways:

  • As nominal yields approach zero, it is hard (if not impossible) for U.S. Treasury prices to go higher. In order for prices to rise, yields have to fall. (Once again, this is a mechanical relationship.) This means that, with the U.S. Ten-year yield below 60 basis points as of this writing, prices cannot rise much further before the nominal yield hits zero.
  • With negative real yields in place — meaning the investment loses money after inflation — bond holders can no longer earn an acceptable return. Negative real yields mean that, even if you are paid with a small amount of yield income each year, you are losing money overall due to inflation. With U.S. Treasuries now sporting real yields that are negative, they incur a cost to hold, as opposed to generating a positive inflation-adjusted return.

When you put those two elements together — U.S. Treasury prices can’t go much higher, and real yields are likely to stay negative for years — the results are devastating in terms of the 60-40 portfolio strategy.

In this brave new world, having 40% of one’s portfolio in U.S. Treasuries results in the net destruction of capital, due to negative real yields after inflation is accounted for.

That is bad— but losing the downside insurance component is even worse.

With nominal yields approaching zero, U.S. Treasuries can no longer rise in value all that much when stock prices fall, or when the Federal Reserve cuts interest rates.

This means the downside protection element previously inherent to the 60-40 strategy is all but gone.  

There is still a scenario, we should add, where U.S. Treasuries can continue rising in value. But it isn’t a pretty one.

If the nominal yield on U.S. Treasuries actually turns negative — imagine, say, the U.S. Treasury Ten-Year Note at a nominal yield of minus 1% — then U.S. Treasury prices can keep going up.

In metaphorical terms, zero is an interest rate “floor” for nominal bond yields — but if the world gets weird enough, the yield could fall through the floor.

If that happened, though, it would create its own set of nightmare circumstances.

When nominal yields are negative, the bondholder isn’t just losing money after inflation, they are losing money period. If you buy $10,000 worth of U.S. Treasuries at a negative 1% nominal yield, and one year left to maturity, you finish with $9,900. 

If anything, allowing nominal bond yields to go negative could create even more havoc than letting them stop at zero.

The U.S. financial system is simply not built to support negative nominal yields. If they arrive, all kinds of multi-trillion-dollar finance mechanisms, from money market funds to mortgage lending to collateral-based commercial finance, could go haywire.

What this means, in sum, is that as U.S. Treasury yields approach zero in nominal terms, the Treasuries themselves become a useless instrument.

They are no longer good for income (because real yields are already negative) and no longer useful as a downside hedge (because price appreciation is capped).

Then, too, we know that the Federal Reserve will deliberately keep real yields negative — meaning that the asset delivers a loss after inflation — for years to come.

The Federal Reserve will do this because they have no other choice.

When the debt mountain gets too large, the only way to keep the game going is to inflate the debt away — and negative real yields are the functional means of doing that.

Given all of the above, the dominance of the 60-40 portfolio, so popular these past few decades, will have to end. The U.S. Treasury side is broken and can’t be fixed.

This further implies greater volatility for stocks in the years ahead. This is because the 60-40 portfolio, while it lasted, had a volatility-smoothing impact.

It is easier to hold a volatile asset (equities) when there is a simple, attractive means of “hedging” that asset, which is exactly why the 60-40 portfolio was so dominant as a setup.

The Treasury side was the inversely correlated hedge, making equities easier to own. So-called “risk parity” funds even took this idea further by leveraging up the bond side (another strategy coming to an end).

When you take that hedge away, equities become harder to hold, as the buffer of capital gains in a declining equity market (via price appreciation on the Treasury side) is removed. This means equity ownership will be less popular, or subjected to larger volatility swings, or both.

If this sea change sounds like it is all downside, and no upside, that is because it is. The inherent upside of the 60-40 portfolio, born of America’s ability to safely accumulate debt and grow the economy at the same time, has all been used up.

The reason the 60-40 portfolio is headed toward the end of its useful life is because the U.S. national debt load, relative to the size of the U.S. economy, has grown so large that “normal” or “healthy” economic growth is probably no longer achievable, let alone sustainable.

The United States, to wit, has been borrowing heavily from the future as long as anyone can remember, throwing more and more debt on the pile, while assuming the reckoning would come “someday” but not in the present moment.

Now, “someday” is finally almost upon us. The 60-40 portfolio will be one of the casualties of its arrival (along with the general functional utility of U.S. Treasuries).