In this edition of Inside Look, we want to talk about the value of a 60/40 balanced portfolio and why it could be making a comeback in today's market environment. This long-held staple of investing for growth and income has been beaten up in the last several years, but we believe it deserves a closer look.
Federal Reserve Provides the Market an Alternative
First off, 2022 was an historically bad year for both stocks and bonds. In fact, it was the first year in more than 100 where stocks and bonds both fell by double digits. As a result, the 60/40 strategy had one of its worst years of performance since the Great Depression. But that doesn't mean it's a strategy that should be thrown out or ignored.
While the 2022 performance was a historic anomaly, the negative press around 60/40portfolios follows a common misconception that when stocks go up, bonds go down, and vice versa. That’s not always the case. During the last 100 years, sometimes they’ve been negatively correlated and other times they’ve been positively correlated. Although correlation is relevant to portfolio performance over a very short time frame, such as one year, the incremental income that bonds historically provide over a longer term has more diversification benefits for long-term investors.
Fixed income returns are dependent on yields, and most long-term fixed income returns are based upon what the yield environment provides at a given point in time. When bond yields were sitting at 1% or less over the previous few years, the prospective income, return, and diversification potential for bonds was historically compromised.
The exceptionally large and rapid increase in interest rates, engineered by the Federal Reserve in 2022 in response to sharply higher inflation, was the major culprit for the negative returns of a typical 60/40 portfolio. However, the good news for long-term investors is that this significant increase in interest rates means that higher bond yields now provide substantially more portfolio diversification benefits through meaningfully more interest income. This gives the crowd chanting “there is no alternative” to stocks during the years of low rates, at long last an alternative to stocks.
One bad year for fixed income can mean a future of opportunity as the yield and rate environment changes. A balanced portfolio has always been a steadying option for the right investor, and especially now.
Today, the 10-year treasury yield is around 4.5% and most corporate bond yields are between 5-6%, with even longer-term bonds becoming more attractive after years of relatively trivial yields. Short-term bond yields are also compelling at over 5%, and with minimal price risk from further increases in interest rates. We believe this current environment provides a vastly better opportunity for income-focused investors wanting to generate higher income, and potentially provide some stability to a portfolio in volatile environment.
Rising Rates Make Value Companies More Attractive
While the rise in interest rates has changed the fixed income investing landscape, it should also signal a shift and broadening of the equity market from one highly focused on growth stocks to now including value stocks.
Mairs & Power is a bottom-up investor focused on companies, not markets. While we pay close attention to macroeconomic factors, we focus on securities and businesses we believe in. While fixed income potential looks better than it has in more than a decade, we’re also examining the opportunities within sometimes overlooked “value” companies. These are businesses with long-term success and durable competitive advantages, but that sit within more defensive sectors like Utilities and Health Care that provide necessary products and services. Stocks connected to higher borrowing costs and inflation (e.g., Consumer Discretionary, Industrials, and Materials) often see a downturn in profits because they’re more dependent on economic growth. Pairing stocks that are more attractive when recession concerns are growing with fixed income can provide further dividend income generation and risk protection.
Alliant Energy and Medtronic are two names that fit well within a balanced strategy portfolio. With attractive valuations and durable competitive advantages within defensive sectors, they can provide investors with consistent returns while lowering downside potential.
Alliant Energy (LNT) is a Wisconsin-based public utility operating primarily in Wisconsin and Iowa. It serves nearly 985,000 electric customers and 425,000 natural gas-only customers, engaging in the generation and distribution of electricity, as well as the distribution and transportation of natural gas. The stock sold off in the fall of 2022, but it has positioned itself to take advantage of the trend toward electricity generation that utilizes wind and solar power. We see it as an undervalued company with good long-term growth potential that provides an above-average dividend.
Held by Mairs & Power since 1969, Medtronic (MDT) is one of the largest medical-device companies in the world. It develops and manufactures therapeutic medical devices for chronic diseases, and we have seen Healthcare hold up better during tough markets. Medtronic is a helpful example of how companies evolve through the years, spending time as a high-growth company, spinning off successful businesses like Inspire Medical (INSP) that we also hold, and becoming a stable company with an above-average dividend and above-average returns on invested capital. Medtronic’s portfolio of therapeutic and diagnostic medical products includes pacemakers, defibrillators, heart valves, insulin pumps, and much more. We consider this Minnesota-based company a safe haven during economic uncertainty and with a good dividend, it can help a balanced portfolio with income generation while maintaining positive returns.
The Long-Term Benefit of a Balanced Strategy
Looking at the market over full economic cycles, the picture for a balanced strategy becomes clearer. The following graph of performance from 1926-2022 shows how including fixed income in an investment portfolio has generally provided positive returns while lowering downside risk over an extended period.
Source: 2023 Ibbotson SBBI Classic Yearbook (1926-2022 data) as of 12/31/2022 | Stock = S&P 500 TR Index | Bonds = Long-term Government Bond TR Index | Standard Deviation = A statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance | Date Range = 12/31/1925-12/31/2022
Those performance numbers show that the 60/40 portfolio isn’t relegated to times of volatility. It has performed well through the ups and downs of numerous market cycles.
Yet, in the current environment where a recession may be unavoidable, playing it safer with investments through a diversified balanced strategy can be a wise choice to mitigate risk and generate consistent income. By zeroing in on stocks and bonds from stable, growing companies and issuers, a balanced strategy can be a successful long-term investing strategy and be a safe place to turn, particularly during an economic dip, should it come to pass.
The mention of specific securities is not intended as a recommendation or an offer of a particular security, nor is it intended to be a solicitation for the purchase or sale of any security.
Top 10 Fund Holdings (subject to change)