- Tuesday, November 14, 2023

Stocks and bonds have taken a drubbing lately, and many people who actively manage investments for their retirement and children’s education are questioning some ancient advice — hedging the risks of associated with the volatility of stock prices by placing only 60% in equities and reserving 40% for bonds.

Stocks are going to have good and bad years, and prices can change abruptly. When the market is down, selling stocks is painful if you need cash to pay college tuition and dormitory fees, buy groceries, and repair the roof at your retirement cottage or satisfy the IRS’ required minimum distributions on tax-sheltered accounts.

Bonds are supposed to provide the ballast.

When the economy starts cycling down, the Federal Reserve often cuts the overnight bank lending rate. That should pull down the auction rates on new Treasury securities with longer maturities — most importantly, 10-year Treasuries, which are the benchmark for mortgages, car loans, corporate bonds and other long-term securities.

When the Fed cuts rates, the values of previously purchased bonds in portfolios should rise, but bonds don’t always go up when stocks are falling.

As stocks took a dive from the end of July to late October, the market interest rate on 10-year Treasuries increased from 3% to about 4.9%, and bond prices took a shellacking.

Conservative investors often rely on bond funds to manage risk. The Vanguard Long-Term Treasury Fund took an 8.5% loss from July to late October.

Last year, the 60/40 strategy had its worst year since 1937, falling 17%. And this year’s performance will hardly reverse those losses.

With stocks and bonds falling together, parents facing college tuition payments and retirees selling securities were in a bucket of pain.

Parents whose children started college in 2023 are at serious risk of asking their offspring to go much deeper into debt than anticipated in their senior year. People who retired in the wake of the pandemic who calculated they just had enough saved are at risk if their fixed income investments are in bonds or bond funds.

Worse, the history of bond and stock prices hardly indicates they move in opposite directions in any predictable manner over the long haul.

A recent study of the correlation between stocks and bonds found that the two asset classes prices tended to move together from 1976 to 2000 and from 2021 forward, and moved in opposite directions only in the intervening years.

But that doesn’t mean bonds can’t be useful to investors to cushion the ups and downs of the stock market.

We’ve just gone through a dramatic period for Treasury securities that likely signals a permanent upward adjustment in longer-term interest rates relative to the expected returns on stocks.

The government is borrowing a lot more, and politicians aren’t inclined to spend less or raise taxes a lot. Bigger deficits increase the annual additions to the supply of bonds.

Housing prices continue to rise, indicating people will have to borrow more to own homes or real estate developers will borrow more to supply more rental housing. These will increase the supply of bonds through government-agency mortgage-backed securities.

Foreign central banks and other investors are diversifying from the dollar. That reduces the demand for Treasury securities.

As the share of retirees in the population increases, they sell bonds and stocks to finance spending. Wealthier retirees with more savings than they need can sell mostly bonds and leave their legacy in stocks; recent data indicate they are doing just that. These things also reduce the demand for bonds.

More supply and less demand mean higher interest rates on Treasuries and bigger returns for investors if they hold bonds to maturity.

Higher interest rates put pressure on the valuations of technology companies, which have driven market returns in recent years. Simply put, higher interest rates reduce the expected present value of future profits for startups and established companies investing in innovations such as artificial intelligence.

The S&P 500 outperformed 10-year Treasury securities by a 5-to-1 ratio from 1998 to 2022. Going forward, that ratio may be lower — perhaps 4-to-1 — but stocks still offer superior returns.

Given the volatility of stocks, it’s better to hedge your bets with bonds if you can mitigate their volatility — create a stable path of redemptions at full value and avoid selling when prices are down.

Put 60% of your holdings in stocks. For emergencies, put 10% in a conventional money market fund — or a state and local fund if you are in a high tax bracket. Invest the remaining 30% in a ladder of Treasuries that will mature as you need college funds or retirement income.

If you buy bonds that mature as you need cash, you receive their full face value. You are not subject to interest rate risk, and you have your money when you need it.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

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