Portfolio Manager Aneet Chachra and David Elms, Head of Diversified Alternatives, evaluate the rationale for holding bonds in the current environment and why the eroding bond pillar raises the importance of true diversification and low correlation in a portfolio.

There are three main reasons to hold government bonds:

1)   Capital Preservation – Bonds are generally less volatile than other asset classes. Short maturity government instruments are especially suited to preserve notional capital.

2)   Income – With U.S. short rates back to zero and the U.S. 10-year Treasury yield at 0.65%1, income is minimal. Prospects don’t look good, either. The expected return of a Treasury bond portfolio is its starting yield – this has been shown both empirically and quantitatively2. Math aside, here is an intuitive explanation – if rates go up after you buy bonds, the immediate capital loss will gradually be offset by higher rates on reinvested coupons. The opposite is also true – current Treasury holders have large capital gains, but now must reinvest at low rates.

3)   Diversification –  The strongest argument for bonds, especially Treasuries, has been portfolio diversification. Treasury prices have generally risen during crisis periods. Exhibit 1 shows all the periods that the S&P 500® Index has dropped more than 10% since 2000, along with the total return of a U.S. 10-year Treasury portfolio over the same dates.

U.S. Treasuries rose in 9 of 10 crisis periods (with only a small loss in the remaining case). On average, they returned about +10% during an S&P 500 drawdown, enough to offset around 40% of the concurrent equity loss. 

Exhibit 1: U.S. Treasuries have Diversified Equities during Crisis Periods

Time Period S&P500 Drop 10-Year Treasury Total Return
Mar 24, 2000 to Oct 9, 2002 -49.1% +34.5%
Nov 27, 2002 to Mar 11, 2003 -14.7% +6.8%
Oct 9, 2007 to Mar 9, 2009 -56.8% +21.3%
Apr 23, 2010 to July 2, 2010 -16.0% +7.7%
Apr 29, 2011 to Oct 3, 2011 -19.4% +15.8%
May 21, 2015 to Aug 25, 2015 -12.4% +0.9%
Nov 3, 2015 to Feb 11, 2016 -13.3% +5.7%
Jan 26, 2018 to Feb 8, 2018 -10.2% -1.6%
Sept 20, 2018 to Dec 24, 2018 -19.8% +3.5%
Feb 19, 2020 to Mar 23, 2020 -33.9% +7.4%
Average -24.6% +10.2%

Source: Bloomberg, January 2000 to March 2020.

However, this feat is unlikely to repeat for mathematical reasons. Members of the U.S. Federal Reserve (Fed), including Chair Jerome Powell, have repeatedly opposed negative short-term rates. Experience from Japan and Europe does not suggest negative rates are a panacea either. Instead the Fed, Treasury Department and Congress all favour deploying large-scale monetary and fiscal programs.

With the caveat that U.S. short-term rates remain at the zero bound (0-0.25%), we can ballpark a floor for Treasury yields. Although 10-year government bond yields are negative in both Japan and Europe, they are positive relative to short-term rates by about 0.15%. Adding this spread to the U.S. Fed Funds rate at 0.05%, results in a floor U.S. 10-year yield of 0.20%. This is also roughly consistent with the intraday low of 0.31% very briefly observed on March 9, 2020.

Both these data points suggest that the yield decline possible for U.S. 10-year Treasuries is from current 0.65% to a low around 0.2% to 0.3%. This decrease would correspond to a 4% total price gain, or less than half the average benefit (+10.2%) achieved during prior equity drops. Notably, the average daily move in the S&P 500 during March 2020 was 5%, so U.S. 10-year Treasuries could only, at their expected maximum, offset a single bad day in stocks.

Treasuries likely provide limited potential return (+4% max) and low portfolio diversification benefit even if the negative correlation environment (bonds rise when stocks fall) of the last 20 years continues.

But bond investors also take the risk that yields increase instead from current low levels, causing capital losses to portfolios. The risk/reward trade-off for government bonds is historically unattractive. Additionally, a rise in longer-dated yields would be especially punitive to risk parity and other levered strategies if the correlation environment turned positive (stocks and bonds fall together).

Treasuries have performed strongly over the last 18 months. Holding bonds (particularly short-term Treasuries) can still preserve capital, but their income and diversification potential is reduced. Meanwhile, the Fed is a large, price-insensitive buyer via quantitative easing that is keeping yields low. In our view, most government bonds are relatively unappealing in the current investing environment.

With this long-standing bond pillar now eroding, finding true diversification and low correlation through other investment choices will become more important to portfolio construction.  

 

1 As at April 17, 2020

2 Marty Leibowitz on Duration Targeting with Bonds – CFA Institute, March 2014