May 03, 2016 - Russ Koesterich
U.S. Treasuries are not cheap. At roughly 2%, nominal yields are less than a third of the 60-year average of 6%, according to Bloomberg data. Although they are not as egregiously expensive as 10-year Swiss government bonds—currently trading at a yield of negative 0.25%—U.S. bonds are offering a relatively paltry real return, even after adjusting for low inflation.
Moreover, government bonds are potentially more volatile. For now, that volatility is being suppressed by the lethargic pace of the Federal Reserve’s (Fed’s) tightening cycle. But there is plenty of risk embedded in traditionally safe government bonds.
Low coupon rates mean that investors get almost all of their cash flow at maturity. This pushes up a bond’s duration or rate sensitivity. In practice, a 10-year bond yielding 2% is more rate sensitive than a 10-year bond yielding 6%. If rates start to rise, bond volatility will be exacerbated by higher durations. Another way of looking at this: With a 2% coupon, a relatively small rate move will wipe out a year’s worth of interest.
But despite high prices and the potential for more volatility, there is still a very good reason to continue to own government bonds: diversification.
Use bonds as a hedge
While government bonds currently produce little in the way of income, U.S. Treasuries have been providing a hedge against equity risk. Since the financial crisis, but really since the bursting of the tech bubble, bonds have been more likely to move in the opposite direction to stocks. This trend has only intensified since the financial crisis.
Why should this be the case and is it likely to continue? Looking back over the past 25 years, a period of low and stable inflation, stock/bond correlation has generally moved in tandem with monetary policy, as measured by the effective federal funds rate. In the 1990s, when investors were more worried about inflation and an aggressive Fed, the correlation between stocks and bonds tended to be positive. However, as the Fed has increasingly pushed the boundary of monetary accommodation correlations have fallen.
What history tells us
Over the past quarter century the level of the fed funds rate has explained nearly 50% of the variation in stock/bond correlations, according to Bloomberg data. Take a look at the chart below. During this period, when the policy rate was above 2%, the average correlation was close to zero. In periods when the fed funds rate has been below 2%, as has been the case since late ’08, the average correlation has been roughly -0.25. (A correlation of 1 means two asset classes move in lockstep. A negative correlation means they move in opposite directions. A zero correlation means their movements are unrelated.) As long as the Fed remains reluctant to raise rates, history would suggest that the correlation between stocks and bonds is likely to remain negative.
A negative stock/bond correlation is important for managing portfolio volatility. Portfolio risk is not simply the sum of the volatility of the individual assets; it is also influenced by the correlation between those assets. To the extent that longer-term government bonds provide diversification—a scenario more likely in an environment in which the policy rate is low—bonds have a role to play in a portfolio, even if they are expensive and more volatile.