When interest rates go up, bonds often become a more appealing investment than stocks. The goal here is to help you figure out how to balance your stock and bond investments to get the best risk-adjusted returns. With the 10-year Treasury bond yield hitting as high as 5% in 2023, Treasury bonds are looking especially tempting, especially since inflation has dipped below 3.5%.
In research by Savita Subramanian from Bank of America Merrill Lynch, she suggests that bond yields between 4.5% to 5% make stocks less attractive compared to bonds. I’ve noticed, with stocks rebounding nicely in 2023, that bonds are already starting to look more appealing than stocks.
Here’s how I see it: if the 10-year bond yield hits 4.5%, I’d split my investments 50/50 between stocks and bonds. At a 5% yield, I’d adjust to 40% stocks and 60% bonds. If yields climb to 5.5%, I’d go 30/70, and at 6%, I’d go as conservative as 20/80, assuming it’s unlikely we’ll see yields go much higher than that.
Historically, a 50/50 split between stocks and bonds has delivered a decent annual return of about 8.3%. Not too shabby, even if future returns dip a bit.
Your specific bond allocation should also reflect your personal situation. I’m on the cautious side myself. With a young family to support, I’m planning to stay home until our youngest starts school, so I can’t afford big risks. At about a 4.2% bond yield, you hit what many consider the ideal balance for a stable retirement income, allowing for a 4.2% withdrawal rate without dipping into the principal. So, you might want to consider an even lower stock allocation than 50%.
Looking ahead, rising rates generally mean a slowdown in borrowing and, eventually, a dip in both corporate profits and the overall stock market. This usually happens with a delay of about a year or two after rate hikes stop.
So, as bond yields rise, consider tweaking your portfolio. For instance, if the 10-year bond yield is at 4.2% and you expect it to drop to 3.5% within a year, you might want to increase your stock allocation, since lower rates generally boost bond prices and stock performance.
But remember, high bond yields are unlikely in the current economic climate. Inflation peaked last year and is on the decline, signaling that bond yields might not reach as high as 5%. It’s more likely that we’ll see rates start to decrease within the next year.
Always align your investments with your personal risk tolerance and financial goals. The financial environment is always changing, and so should your strategy. Whether you’re nearing retirement or still in the wealth-building phase, make sure your asset allocation fits your needs and reflects the economic landscape.
