Much has been written about the demise of the 60/40 model, but I am willing to make the argument that there may still be life in it yet – or at least a variation of it.

The traditional go-to portfolio allocation model: the 60/40 portfolio doesn’t work. It hasn’t worked in a long time. The 60/40 portfolio allocates 60% of assets to stocks and 40% to bonds (typically, U.S. treasures).

The idea behind the model is that, in a bear market, a portfolio’s fixed income portion would preserve the portfolio by compensating for stock declines. This is based on the fact that bonds have traditionally moved in the opposite direction of stocks. The 60/40 model worked in the ’80s when treasury rates hovered around 10%, but with current 10-year yields below 1%, the model doesn’t work.

The problem with the 60/40 model is that the security that bonds have traditionally provided has eroded – for two reasons:

• Bonds haven’t always moved in the opposite direction of stocks.
• The current 10-year Treasury yields .919% – insufficient to compensate for major stock declines.

If bonds aren’t negatively correlated to stocks when stocks fall and bonds fall with them, what is there to catch the portfolio’s fall? A case in point:  when the stock market crashed last March due to the economic fallout from the Coronavirus, treasury yields fell as well.

In a recent letter to clients, Morgan Stanley warned that returns from a 60/40 portfolio would be the lowest in 100 years. It projected returns to be just shy of 3% a year over the next decade. Average annual inflation over the past 20 years has been around 3.22%. Considering inflation, that’s a projected net annual loss of .22% per year over the next decade if you stick to the 60/40 model.

Here’s the catch:  There is a variation of the 60/40 model that works.

A variation of the 60/40 model works, but it doesn’t involve public stocks and bonds. It involves private equity and private debt. There is value to a portfolio with a mix of equity and fixed income components. But, it’s not found on Wall Street where 10-year Treasury yields are below 1%, and the stock market is a crash waiting to happen.

The value of an equity/debt income portfolio can be found in the private markets.

Private equity investments serve the role of public stocks in the traditional 60/40 model by offering potential upside but with one big difference – one big advantage actually. The difference between private equity investments and public stocks is that many private equity opportunities offer cash flow that most stocks can’t – adding another layer of potential profits.

Mixed with private debt such as fixed income assets like promissory notes and term certificates, this equity/debt allocation model can balance the 60/40 model in the public sector used to provide but is no longer effective.

So you have the upside of private equity, but what about private debt returns?

We all know the value of private equity investments in real assets that can deliver IRRs over 15% in the right segments and with the right operators, but what about private debt returns?

According to the CFA (Chartered Financial Analyst) Institute, the average monthly return from private debt according to its private credit index was 1.53% a month. That translates to an 18.36% annual return. You can now see the value of including private debt in your portfolio.

Now it makes sense. A portfolio allocated to a mix of private equity with a conservative IRR of 12% and private debt returning a conservative 12% a year achieves the balance of the 60/40 portfolio is supposed to provide.

In the private markets, with a long-term investment window, the debt portion will be there to pick up the slack by ensuring a continuous income stream when the equity portion lags. It’s no wonder investors were piling into private debt this past year. Perhaps smarting from a halt in income, investors sought out fixed income sources backed by hard assets with long-term windows to ensure future cash flow.

For savvy investors with long-term investment windows, there’s a strong case for including private debt in your portfolio – not only in uncertain times but at all times.

Balance by an equity portion that can offer significant upside, including private debt in a portfolio, ensures a steady hand when the equity portion falters. That’s why you should add private debt to your portfolio.