Rising yields raise the portfolio appeal of bonds and diversified investing

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Higher global bond yields on recalibrated interest rate expectations and a rebound in appetite for stocks have hurt investors with existing fixed income positions. At the time of writing, the policy-sensitive German 2-year yield stood roughly 17bps higher on the week and was on course for its sharpest weekly rise in two months. And Japanese 10-year yields climbed to their highest levels since 22 October in Asian trading, in tandem with higher US government yields on news that President Trump was not seeking a peace deal with Iran and as investors weighed comments from Federal Reserve President Waller around the possibility of a 50bps rate hike at the Fed's December meeting.

But elevated starting yields have restored rather than diminished the appeal of the traditional balanced (60% stock, 40% bond) portfolio. While equities can provide long-term growth, high-quality bonds once again offer meaningful income, potential capital appreciation if growth slows, and a cushion against some equity market declines.

Bonds have returned to the core The reset in yields has materially improved the role bonds can play in portfolios. After the global financial crisis, low interest rates left fixed income offering limited income and relatively little protection against an equity market drawdown, while exposing investors to the risk of rising yields. Current higher starting yields matter in several ways. They increase the income available from bonds and provide a greater cushion against negative returns in case rates increase further. They also create scope for capital appreciation if inflation moderates, economic growth weakens, or central banks eventually reduce interest rates. The portfolio role of bonds extends beyond expected returns. High-quality bonds can help preserve capital and may diversify equity exposure when economic growth disappoints. Their senior position in the capital structure also generally makes them less risky than equities issued by the same company.

60/40 is stronger, but not invulnerable. The revival of bond yields improves the case for a 60/40 equity-bond portfolio. But it is not guaranteed that bonds will offset every equity decline. The diversification benefit depends partly on why equity markets are falling.

High-quality bonds have historically been more effective equity diversifiers during periods of low or stable inflation. If growth weakens and inflation moderates, bond prices may rise as equities come under pressure. If inflation remains elevated and interest rates rise, stocks and bonds can decline together. That distinction is important at present, as investors face several plausible paths for growth, inflation, fiscal policy, energy prices, and geopolitical risk into the year ahead.

Completion assets can address different risks. Uncertainty and the need to think in terms of market scenarios makes the case for completion assets stronger. Completion assets can earn their place by doing a specific job that the core may not perform consistently. That might include generating differentiated returns, providing income, reducing sensitivity to equity markets, or helping preserve purchasing power during periods of elevated inflation.

Hedge funds may provide alternative sources of return when equities and bonds face pressure at the same time. Real assets can address a different set of risks. Commodities have historically displayed relatively low correlation with traditional asset classes and may benefit when physical supply is constrained or inflation remains elevated. And private infrastructure may offer relatively predictable and potentially inflation-linked income, while providing exposure to long-term investment in electricity networks, data centers, electrification, energy security, and more resilient supply chains.

So, the return of meaningful bond yields has made the traditional balanced portfolio relevant again. A diversified mix of equities and high-quality bonds can provide a more credible combination of growth, income, and capital preservation than it could during the low-yield era.

We currently rate high grade and investment grade bonds as Attractive. We favor exposure to short- to medium-duration high-quality bonds, while remaining more cautious on longer maturities given fiscal concerns and elevated issuance. We also rate high yield and emerging market bonds as Attractive, supported by elevated yields and, in aggregate, resilient fundamentals.

However, 60/40 is a foundation, not a complete answer. We believe investors should also look at commodities, real assets, and select structured strategies as ways to enhance returns, improve portfolio resilience, and best match specific goals with portfolios, subject to careful risk management. Private investments in particular can involve illiquidity, limited disclosure, uncertain cash flows, leverage, capital calls, and blind-pool risk.

Finally, portfolio discipline matters as much as portfolio design. A 60/40 US equity-bond portfolio invested in 2020 would have drifted to about 80/20 if left untouched, reflecting the stronger performance of equities. Regular rebalancing helps restore the intended risk profile, reduce unintended concentrations, and prevent recent outperformers from determining the portfolio’s future behavior.