With interest rates rising across Treasury bonds, municipal bonds, and corporate bonds, there comes a point where owning bonds becomes more attractive than owning stocks. The objective of this article is to figure out an appropriate stock allocation by bond yield for a better risk-appropriate return.
With the 10-year Treasury bond yield rising to as high as 5% in 2023, Treasury bonds look relatively more attractive. This is especially true given inflation is below 3.5% again.
In a research report written by Savita Subramanian, Head of US Equity & Quant Strategy at Bank of America Merrill Lynch, she believes the 10-year bond yield has to reach 4.5% – 5% before US equities start to look less appealing than bonds.
But I say after a nice rebound in stocks in 2023, bonds are already now looking more attractive than stocks.
Historical Stock Allocation By Bond Yield
Below is an interesting chart that shows the average allocation to stocks during different rate regimes. When the 10-year bond yield is between 4% to 4.5%, the average stock allocation is roughly 63%. But when the 10-year bond yield is between 4.5% to 5%, the average stock allocation actually goes up to 65% before declining.
Subramanian says, “based on several tested frameworks, 5% is the level of the 10-yr Treasury bond yield at which Wall Street’s average allocations to stocks peaked, and so is their expected return of the S&P 500 over the next decade.”
I get why the bar charts would fall (lower stock allocation) after the 5% level. But it's interesting to see how the stock allocation is lower when rates are between 1% – 4.5%. It's also interesting to see how there is an uptick in stock allocation once the 10-year bond yield surpasses 9.5%.
My guess is that at several points between 1985 – 2018, despite low risk-free rates, investors were simply too afraid to invest aggressively in the stock market because there was some type of financial catastrophe going on. During the start of the pandemic, the 10-year bond yield dropped to 1% due to a flight to safety. In other words, investors preferred holding a bond that yielded just >1% versus potentially losing 10% – 50% of their money holding stocks.
The Bond Yield Level Where I'd Switch
It has generally been OK to invest in stocks in a rising interest rate environment up to a point. A rising interest rate environment means there is inflationary pressure due to a tight labor market and strong corporate profits. Given corporate profits are the foundation for stock performance, a rising interest rate environment is an epiphenomenon.
At a 4.5% 10-year Treasury bond yield, I would go 50 stocks / 50 bonds. At 5%, I would go 40 stocks / 60 bonds. If yields rise to 5.5% I would go 30 stocks / 70 bonds. And at 6%, I would go 20 stocks /80 bonds. I stop at 6% since it's unlikely the 10-year bond yield will get there.
We know that based on history, a 50/50 weighting has provided a decent ~8.3% compounded annual return. A 60/40 stocks/bonds allocation provides a slightly higher historical compound return. Not bad, even if the returns are slightly lower going forward.
Bond Allocation Depends On Your Age And Stage In Life
But remember, you're not me.
I'm more conservative than the average 46-year-old because both my wife and I are both unemployed in expensive San Francisco with two young children. I cannot afford to lose a lot of money in our investments because I'm determined to be an SAHD until our daughter goes to kindergarten.
At a ~4.2% 10-year bond yield, we're now at the popularly espoused retirement withdrawal rate where you will maximize your take and minimize your risk of running out of money in retirement.
If you can earn 4.2% risk-free, that means you can withdraw 4.2% a year and never touch principal. Therefore, perhaps you want to have an even lower stock allocation than 50%.
A 40% equities / 60% fixed income portfolio that has returned a historical 7.8% compound annual return since 1926 sounds quite reasonable. Of course, past performance is no guarantee of future performance.
Suggested Stock Allocation By Bond Yield
Eventually, higher rates will slow down borrowing because it makes borrowing more expensive. As a result, corporate profits and the stock market will decline, all else being equal. There is generally a 12-24-month lag after the Fed is done hiking where the economy begins to obviously slow down.
Based on historical Wall Street stock allocation data, historical inflation rates, and historical returns, here is my suggested stock allocation by bond yield to consider.
The suggested allocation percentages are for steady-state portfolios that planned to be invested for years as opposed to a house downpayment fund. Preferences will obviously vary, so use the chart as a gut check and make your own decision.
The goal is to always balance risk and reward. You should try and invest as congruently as possible with your risk tolerance. The investor who tends to blow themselves up generally underestimates their true risk tolerance.
Of course, in a rapidly changing interest rate environment, changing your stock and bond asset allocation so quickly may not be prudent. There are tax consequences if you're rebalancing in a taxable portfolio. Hence, you must try to anticipate where interest rates are going and asset allocate accordingly.
For example, let’s say the 10-year Treasury bond yield is at 4.2%. If you believe it is going to 3.5% in one year, you may want to shift your stock allocation from 45% to 60%. The thing is, bonds will likely perform well if rates move down as well. Finally, don’t forget to pay attention to inflation and real interest rates.
Much Higher Bond Yields Are Unlikely
Inflation peaked at 9.1% in mid-2022 and there are plenty of signs the economy is slowing. Therefore, I don't think the 10-year bond yield will reach 5%. It may hit 4.5%, but that's about the upper limit given we've already gone through 11 rate hikes.
The more likely scenario is that the 10-year Treasury bond yield starts to fade within 12 months. In the process, the yield curve begins to steepen as the Fed finally starts cutting rates.
I still think there will likely be another recession, but another shallow one that doesn't last longer than one year.
The majority of you have likely seen your net worths double or more since the 2008 financial crisis. As a result, the return on your larger net worth no longer needs to be as great to return the same absolute dollar amount.
Hence, I think it's worth following staying disciplined with your stock allocation based on bond yields.
Asset Allocation Depends On Net Worth Growth Targets
Your asset allocation also depends on your net worth growth targets. The lower your net worth growth target, the more conservative your asset allocation can be.
When I left my day job in 2012, I decided to aim for a 5% annual rate of return on my after-tax investment portfolio. It sounds low now, but back then, the risk-free rate was closer to 2.5%.
With a larger net worth today due to the bull market, luck, and some hustle, all I need is a 1% annual return to match the absolute dollar amount I desired in 2012. But by the Power of Grayskull, I can now get 4.2% – 5.4% risk-free return. This is a huge boon in this high interest rate environment. It is only logical I reduce my stock exposure.
All of you should go through the exercise of figuring out your asset allocation at different 10-year bond yield levels. Run your investments through an Investment Checkup tool to see what your current asset allocation is compared to what you want. Asset allocations can shift dramatically over time.
Good-enough investing is all about understanding different scenarios and managing your risk. You might like conservative returns with lower risk because you're retired. Or you might be fine with a higher allocation to stocks because you're still in the capital accumulation phase.
Everybody's financial situation is different. Make sure your stock and bond allocation make sense based on your goals and the current economic environment we're in!
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