With the short end of yield curves pinned at zero and the long end depressed, government bonds may not be the portfolio hedges they used to be.

Today’s CIO Weekly Perspectives comes from guest contributors Ashok Bhatia and Adam Grotzinger.

With interest rates in the U.S. having now followed their Japanese and European counterparts to zero, it’s rational for investors to reconsider the hedging effectiveness and portfolio benefits of maintaining allocations to risk-free U.S. government securities.

Allocations to government bonds have long provided a range of portfolio benefits for equity- and credit-focused portfolios. Is this about to change?

Limited Upside

The reasons to suspect that a change may be brewing are straightforward.

With 10-year Treasuries yielding less than 1%, bond math suggests that the ability to generate outsized gains has been significantly reduced, even in longer maturities. Even if longer-term government bonds trade to negative yields—and it is not our view that they will—the absolute return upside in these securities has become quite limited.

Another reason to think a change may be occurring relates to the shifting dynamics in Treasuries over the past few months.

The Treasury yield curve has been exhibiting somewhat consistent directional behavior. It is steepening when rates rise, and flattening when rates fall. That is not typical yield curve behavior. In the past, in addition to these patterns we have seen the curve steepen as short-term rates fell further than long-term rates, and flatten as short-term rates rose more than long-term rates.

Today’s more consistent directionality does follow the dynamics of the Japanese and European curves after their central banks went to zero, however. Effectively, the front end of these bond markets has been “pinned” at zero and all the volatility associated with expectations for growth, inflation and monetary policy has become concentrated in the longer maturities.

At minimum, we think this dynamic will persist and lead to a change in the hedge characteristics of longer-maturity government bonds. In risk-off environments, we would continue to expect them to act as a reasonably effective hedge for risk portfolios. In risk-on environments, however, the upward pressure that would normally be felt in yields at the front end of the curve is likely to be felt at longer maturities instead, potentially leading to a more volatile and uncertain path for portfolio hedging.

As a result of these changing yield-curve dynamics, while negative correlations between Treasury and equity returns persist when looking back over a medium-term horizon, the magnitude has diminished and the margin of error around estimates of current correlation has widened.

Substituting ‘Close-to-Risk-Free’ Assets for Treasuries

We are reluctant to call the end of this period where government bonds have been an effective diversifier for risky portfolios. It has been a long-term and powerful trend and one should rightly demand significant evidence before declaring a multi-decade trend has ended.

That said, we are taking several actions in our multi-sector fixed income portfolios that other investors might consider.

In our view, the changing correlations between risk assets and Treasuries argue for a reduction in the amount of risk-free securities held as a hedge. But what can we use to replace those risk-free assets?

With the Federal Reserve’s new purchase and lending programs, a range of assets (such as agency mortgage backed securities (MBS), AAA-rated asset backed securities (ABS), commercial mortgage backed securities (CMBS) and even investment grade credit are now being bought by the central bank.

If the Fed will lend at high leverage levels with non-recourse financing against AAA CMBS, how different is that from a risk-free Treasury, from an investor’s perspective? Or agency MBS, which also offer higher income and are one (small) step away from Treasuries in terms of credit risk?

In our view, these other assets could provide higher income and we would expect them to demonstrate greater hedging benefits against riskier assets than they have done in the past as they increasingly look more “risk-free.”

The End of the Trend

Long-term trends tend not to end suddenly. The last 30 years have seen a powerful backdrop of disinflation, falling real yields and falling risk premiums, which has benefited just about every financial asset.

It’s premature to say that’s over. But bond returns do ultimately come down to math, and very low interest rates suggest it’s time to think about alternatives to the government bond-based hedging strategies that have been so successful over the past decades.

In Case You Missed It

  • Bank of Japan Policy Rate Decision: The BoJ made no changes to its policy stance
  • U.S. Retail Sales: +17.7% in May
  • NAHB Housing Market Index: +21 to 58.0 in June
  • Eurozone Consumer Price Index: Decreased -0.1% month-over-month and increased 0.1% year-over-year
  • U.S. Housing Starts: +4.3% to SAAR of 974,000 units in May
  • U.S. Building Permits: +14.4% to SAAR of 1.22 million units in May
  • U.S. Initial Jobless Claims: +1.51 million in the week ending June 13
  • Japan Consumer Price Index: Core CPI declined 0.2% year-over-year in May

What to Watch For

  • Monday, June 22:
    • U.S. Existing Home Sales
    • Japan Purchasing Managers’ Index
  • Tuesday, June 23:
    • Eurozone Purchasing Managers’ Index
    • U.S. New Home Sales
  • Thursday, June 25:
    • U.S. Durable Goods Orders
    • U.S. 1Q 2020 (Final)
  • Friday, June 26:
    • U.S. Personal Income and Outlays

Statistics on the Current State of the Market – as of June 19, 2020

Market Index WTD MTD YTD
S&P 500 Index 1.9% 1.9% -3.2%
Russell 1000 Index 2.0% 2.1% -2.9%
Russell 1000 Growth Index 3.1% 3.3% 8.7%
Russell 1000 Value Index 0.5% 0.6% -15.2%
Russell 2000 Index 2.3% 1.8% -14.4%
MSCI World Index 2.1% 3.0% -5.2%
MSCI EAFE Index 2.1% 4.7% -10.0%
MSCI Emerging Markets Index 1.5% 7.9% -9.3%
STOXX Europe 600 2.7% 5.0% -11.3%
FTSE 100 Index 3.1% 3.7% -15.2%
TOPIX 0.8% 1.2% -6.9%
CSI 300 Index 2.5% 6.5% 0.8%
Fixed Income & Currency      
Citigroup 2-Year Treasury Index 0.0% 0.0% 2.8%
Citigroup 10-Year Treasury Index 0.0% -0.5% 12.0%
Bloomberg Barclays Municipal Bond Index 0.1% 0.6% 1.9%
Bloomberg Barclays US Aggregate Bond Index 0.2% 0.4% 5.9%
Bloomberg Barclays Global Aggregate Index 0.0% 0.7% 2.8%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.2% 1.6% -2.2%
ICE BofAML U.S. High Yield Index 0.9% 2.6% -3.2%
ICE BofAML Global High Yield Index 0.7% 2.9% -3.3%
JP Morgan EMBI Global Diversified Index 1.0% 3.4% -2.9%
JP Morgan GBI-EM Global Diversified Index -0.5% 1.1% -6.3%
U.S. Dollar per British Pounds -1.4% 0.0% -6.7%
U.S. Dollar per Euro -0.6% 0.5% -0.4%
U.S. Dollar per Japanese Yen 0.3% 0.7% 1.6%
Real & Alternative Assets      
Alerian MLP Index 1.8% 1.1% -29.4%
FTSE EPRA/NAREIT North America Index -2.4% 3.9% -20.6%
FTSE EPRA/NAREIT Global Index -0.9% 5.0% -19.6%
Bloomberg Commodity Index 1.4% 1.6% -19.9%
Gold (NYM $/ozt) Continuous Future 0.9% 0.1% 15.1%
Crude Oil WTI (NYM $/bbl) Continuous Future 9.6% 12.0% -34.9%

Source: FactSet, Neuberger Berman.