A 60/40 portfolio (60% allocated in Equities and 40% in fixed income) is often seen as a balanced approach to investing. High-quality bonds typically help to stabilize a portfolio when equities sell-off. However, in 2022 that relationship did not materialize as investors witnessed a simultaneous drop in fixed-income prices and equities. At the October lows of the market, the Investment Grade Corporate Bond ETF (LQD) was down over -25%, which almost matched the -27% drop in the S&P500. Needless to say, bonds were unable to offer much protection as yields rose at a rapid pace in response to government rate hikes. The silver lining to all this is that investors are now able to purchase or rebalance into bonds at yields that are much higher than the historical average.

Over the last 15 years, bond yields have offered a range of 0.5% to 2%. To earn greater yields, one had to accept higher volatility and risks by entering the high-yield bond market. However, with the significant re-pricing of real interest rates in 2022, this is no longer necessary with sovereign and corporate bonds yielding above 5%.

Should central banks start cutting rates in the future, they are not likely to fall back to zero. This is especially so since the government aims to prevent inflation, leverage, and investment speculation from reasserting itself. Therefore, with bonds paying mid-single-digit returns, investors are encouraged to reconsider their allocation to stocks going forward. Should investors purchase medium to longer-term bonds, there is also a possibility that future rate cuts could offer capital gain upside that could be secured prior to maturity.

To appreciate the current level of bond yields, one should recall that dividend yields from stocks used to handily beat bond yields over the last decade. However, looking at the charts below, the 10 year bond yield currently outstrips most equity sectors. Especially for the US, there is not one sector that pays more income than the 10 year bond.

That being said, we should not overlook the fact that dividend stocks have the potential for growth in the stock price. Moreover, the average growth in the dividend rate for companies within the MSCI world index is expected to be around 6% over the next 3 years. This gives investors a higher level of protection against inflation that bonds may not be able to offer. Companies that grow their dividends also tend to be more disciplined and of higher quality, which should result in less volatility over time. And as pointed out above, there are a handful of sectors in Canada where dividends still have a yield advantage over bonds. This includes financials, utilities, and infrastructure. Finally, with both Canadian and US governments potentially passing new laws to tax share-buy-backs, companies may decide to use excess earnings to payout more dividends. Overall, one should not give up on holding on to core dividend equities despite ongoing volatility in the market.

A more balanced approach between equities and bonds is going to be important going forward. A weighting in higher dividend companies that can grow should give investors the protection they need in case inflation remains high, while an increased weighting towards bonds could be critical in the case of a recession. Speak to us regarding rebalancing your portfolio in preparation for 2023.