Given the consternation over equity valuations and the lure of rising bond yields, this may seem like a sensible approach, even instructive for retail investors reconsidering their own portfolio allocations. Yet history suggests stocks are necessary for growth even when valuations favor bonds, and furthermore that copying pension fund trading can be a losing strategy for individuals.
It’s misleading to look at high bond yields in isolation since some of the increase in recent years is due to higher anticipated future inflation. What matters is the “real” or inflation-adjusted return that is best measured by the yield on Treasury Inflation-Protected Securities, or TIPS.
The current 10-year TIPS yield is 2.21%. Investing in 10-year Treasuries has historically returned 36% more than the TIPS yield at the time of purchase, measured in annualized real returns over the subsequent 10 years. The premium is because a fixed-rate bond investor takes the risk of inflation differing from expectation, while a TIPS buyer is insulated from that risk. Based on history, buying long-term Treasuries offers an expected 3.01% annualized real yield over the next 10 years, with a standard deviation of 1.02%.
A comparable figure for equities is the inverse of the Cyclically Adjusted Price Earnings (CAPE) ratio. Stocks are selling for 34.41 times earnings, translating to an earnings yield of 1/34.41 or 2.91%. As a first approximation, earnings can be expected to grow with inflation, so this is comparable to the 2.42% TIPS yield. However, historically shareholders have only realized 94% of the earnings yield at the time of purchase because earnings overstate economic reality — or, if you prefer, because corporations do not return the full value of earnings to shareholders. Therefore, if history is a guide, the S&P 500 Index has an expected annualized real return of 2.73% over the next 10 years, with a standard deviation of 4.39%.
Of course, pension fund staff and consultants do far more sophisticated calculations than relying only on current market parameters and long-term historical averages. But the numbers seem to indicate that 10-year Treasuries offer a higher expected 10-year real return than the S&P 500 at a much lower level of risk. It certainly makes greater sense to hold more bonds and less stock today than 10 years ago when the S&P 500’s earnings yield was 4% and TIPS were yielding 0.5%.
On the other hand, a recent Wall Street Journal article noted funds were taking risk off the table since they could get equity-level returns with only bond risk. Unfortunately for that happy view, the expected return on both bonds and stocks is well below the average real return assumption of 4.4% among state and local pension funds, which are 25% underfunded using an optimistic return assumption. Pension funds have cut their nominal return assumptions by about 1% over the last 20 years, from around 8% to around 7%, but they’ve cut their inflation expectations even more so their real return assumptions, the ones that really matter, have gone up.
Using the numbers above based on long-term history, investing in the S&P 500 leads to a 64% chance of pension funds losing ground over the next 10 years — increasing their underfunded ratio — while investing in 10-year Treasuries gives an 86% chance of falling farther behind. Bonds may be looking up relative to stocks, but the overall financial environment is bad news for pension funds. Although stock market gains have helped cut underfunding, it’s too early to play it safe by taking risk — and expected return — off the table. Pension funds that want to avoid running out of money to pay benefits cannot afford to derisk in current market conditions.
Not all the money getting pulled from stocks is going to bonds. A big chunk is going to private equity, which behaves like a levered investment in small-cap stocks. Each dollar going from public to private equity increases equity exposure.
Another popular destination is private credit. While this has some bond-like characteristics, it also carries significant equity risk, and has limited interest rate exposure. Alternative assets like real estate and commodities, as well as many (but not all) hedge fund strategies can have equity exposure as measured by Beta of around one-half.
There’s a good case for diversification out of overvalued S&P 500 stocks into other forms of equity risk, and certainly the risk/return ratio on bonds looks attractive relative to history. Should individual investors follow the lead of pension funds? On one hand, these funds have professional managers and analysts, and the advice of consultants and sell-side researchers. On the other hand, they have institutional and political constraints that can override pure financials. Committee decisions with legislators and the public kibbitzing and Monday-morning quarterbacking may not be financially optimal. Retail investors may also be hindered by a lack of access to private-market investments.
Turning once again to history, since World War II, in periods like today when pension funds were increasing fixed-income exposure, stocks have delivered annualized real returns of 7.8%, strongly beating the 0.3% in bonds.1 In the periods when pension funds were shedding bonds, stocks delivered 6.3% compared to 2.7% in bonds. So, while stocks outperformed bonds in both environments, the advantage for stocks was much greater if you bought stocks when funds were selling them, and sold bonds when funds were buying them.
Rising interest rates and the fear of giving back stock market gains are pushing pension fund managers to move capital from stocks to bonds. Goldman Sachs Group Inc. estimates that funds will pull $325 billion from stocks in 2024 on top of the $191 billion withdrawn in 2023, with some of that going into bonds.
1. Calculations based on Federal Reserve data on pension fund investments and returns from Yale University professor Robert Shiller.
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