Bonds still hedge, just not as well

Russ discusses why investors still should hold Treasuries, just a bit less of them.

Assets with expected returns of less than 1% do not make for a compelling sales pitch. Despite this limitation, Treasuries can still serve one purpose: dampening portfolio volatility. Going forward they’re still likely to perform this function, just not as well. This suggests owning a bit less of them.

When I last discussed Treasuries in mid-April, I advocated for long-dated bonds as a hedge. Since then Treasuries have traded within a narrow range. Yields are little changed even as stocks have surged and the economy has shown surprising resilience. Treasuries appear caught between investors new-found love for risk and a Federal Reserve that keeps buying them anyway.

Problem is convexity, not correlation

One obvious reason Treasuries have not done much: They have not been needed. Since mid-April global stocks are up approximately 15% in dollar terms, while equity volatility is down by 35%. While certain hedges, notably gold, have rallied, investors have been adding back risk, not taking it off.

Interestingly, during those brief periods when equities have wobbled, stocks and bonds have still tended to move in opposite directions. This dynamic is visible in stock/bond correlations, which remain decidedly negative and close to their 10-year average (see Chart 1).

Correlation of bond and equity returns

Correlation of bond and equity returns

Source: Refinitive Datastream, chart by BlackRock Investment Institute, Jul 03, 2020
Notes: the line shows the correlation of daily U.S. 10y Treasury returns and S&P 500 over a rolling 90-days period.

From a portfolio construction perspective, the problem is not that bonds are doing the wrong thing; they’re just not doing much of anything. With its open-ended purchase program, the Fed has crushed bond volatility. The MOVE Index, a measure of volatility on U.S. Treasury options, is close to a five-year low and below where it was back in February. Conversely, equity volatility remains well above average and roughly twice where it was in February. Elevated equity volatility combined with muted bond volatility has resulted in a less efficient hedge. While bond moves are in the right direction, Treasuries are just not moving enough to have the same impact on a portfolio.

Still useful in a Pinch

This does not mean that investors should abandon Treasuries. With the 2-30 spread (the difference between the yields of 2 and 30 year Treasuries) at 130 basis points (bps), near the upper end of the three-year range, there is still room for long-term rates to fall if markets correct. This was in fact the case during the short but acute selloffs in May and June. In both instances long duration bonds performed well, gaining around 4% in each instance.

But outside of these short-lived blips and the potential for a longer and more severe correction, bonds are not likely to do much. The Fed is keeping volatility down and rates rangebound. As a result, while investors should still maintain an allocation to long-dated Treasuries, they will have to look to other instruments – currency, gold and/or options – as additional tools in their arsenal. Treasuries can still serve as a useful hedging instrument, just a slightly more blunt one.

Russ Koesterich
Russ Koesterich
Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and is a regular contributor to The Blog.