Viewpoints

September 20th, 2019 | by

Still a Place for Bonds

  • Despite extremely low yields, high-quality government bonds still merit a portfolio allocation.
  • Such bonds are an important component of portfolio risk management.
  • Their hedging quality helps ensure that investors will earn the equity risk premium.

The surge in Treasuries (among other “safe haven” assets) on Monday, September 16, 2019, reinforces the role of high-quality fixed income in a diversified portfolio. It’s no secret that the yields available today on quality bonds such as Treasuries, Agencies, and Municipals are miserly. I have recently been asked by a number of investors whether they should continue to hold or to purchase such bonds– or shift the money into higher-income assets such as high-yield bonds or preferred stocks. I believe quality investment-grade fixed income, even at today’s low yields, still plays an important role in a well-diversified portfolio.

To explain why, let me briefly describe my fixed-income philosophy. Bonds generate some income for the portfolio, but the risk-management qualities of short-term, high-quality government bonds (including munis) are even more important. These assets reduce total portfolio volatility and provide liquidity and stability.

Earning the Equity Premium

This is in part a behavioral story: Historically, investors have been well compensated for taking risk in equities—from January 1926 to August 2019, the equity risk premium (S&P 500 Index vs. 1-Month Treasuries) for US stocks was 6.8%. But equities are volatile; too many panicky investors dump their stocks in turbulent times and don’t earn the equity premium. Short-term, high-quality bonds can smooth the ride and keep investors in their seats.

Instead of looking at an asset class such as bonds in isolation, we examine what it contributes (or adds) to a diversified portfolio. Short-term, high-quality bonds are typically negatively correlated with equities, which makes them a valuable hedge. For instance, during the 15 years from September 2004 to August 2019, the correlation between 5-Year Treasury Notes and the S&P 500 Index was -0.32. By contrast, during the same time frame, high-yield bonds, as represented by the Bloomberg Barclays High Yield Corporate Bond Index, had a positive 0.72 correlation with equities, which implies that they behave much like stocks and do not provide the same portfolio diversification benefit as short-term Treasuries. This makes intuitive sense: as with stocks, high-yield bonds benefit from a strengthening economy, whereas Treasuries tend to shine when growth weakens or as a “safe haven” in a time of crisis.

To better understand the risk mitigation quality of high-grade government bonds, let’s examine how different asset classes behaved during the violent storm of the 2008 Global Financial Crisis. Exhibits 1 and 2 illustrate what transpired during 16 months of market carnage from November 2007 to March 2009. Note the resilience of Treasuries during the turmoil. High-yield bonds slumped and “bond proxies,” including preferred stocks and MLPs, provided none of the portfolio diversification benefits of short- or medium-term US Treasuries. Disciplined, level-headed investors should tap into the liquidity of government paper in their portfolios at times like this to purchase stocks, REITS, and other bombed-out asset classes at bargain prices.

In short, we can’t do anything about the very low yields on offer today for short-term, high-quality government bonds. At the same time, we still shouldn’t abandon these assets, which play a valuable risk-management role by balancing riskier investments such as stocks, REITS, and commodities and lowering total portfolio volatility.

 

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