By Tom Wickers, Hottinger & Co
Modern Portfolio Theory, created in the 1950s, stressed the importance of diversifying assets to reduce volatility and smooth returns. Government bonds have played a key role in diversification, providing a stable income source as well as the hedging of risk assets. These safe-haven assets perform well in times of market stress, and as such have been one of the best performing asset classes of 2020[i], returning an average of 6.3% Year to Date (YTD). Even one of the best performing indices of the year, the NASDAQ which has returned 32.8%[ii], did not significantly overshadow the 30-year Treasury index which has still registered returns of 20.7% YTD[iii]. However, bond yields have reached all-time lows in the past few months and investors are rightly reassessing whether assets with low or negative yields should still feature in their portfolios.
There have been very few success stories for economies this year. Spending and employment have slumped worldwide, and it is only recently looking like there is an end in sight to the turmoil. Government bond yields have been uncomfortably meagre for the past decade, and in September, the daily rate on a 10-year Treasury yield fell to an all-time low of 0.52%[iv]. Recently yields have edged higher as a result of hopeful vaccine efficacy news and the 10-year Treasury yield has held at 0.85% at the time of writing[v]. Regardless, returns from investing in government bonds look likely to disappoint for the foreseeable future. Real yields are flat at best and the German bund nominal yield appears to be firmly cemented in negative territory. It is clear that government bonds no longer provide a substantial and stable source of income but there are still two enduring justifications for holding them.
Gilts and Treasuries continue to provide a hedge in recessions
Ever since inflation stabilised at lower levels in the 1990s, one of the most attractive qualities of these ‘risk-free’ assets has been the largely uncorrelated returns to equity markets and the tendency to appreciate in recessions when equities were at their worst. When funds need to be moved or withdrawn during a recession, the offset that government bonds provide to portfolios is extremely valuable. Equity prices can remain suppressed for years and dampening the effects of market shocks remains an attractive quality for portfolios with any level of intolerance to risk. J.P. Morgan conducted a study on the performance of government bonds in the COVID-19 market slump in Q1 this year[vi]. They found the appreciation in positive-yielding bonds offset a significant proportion of the equity market’s negative performance [Figure 1]. In fact, the 10-year US Treasury provided a similar level of hedging potential to portfolios as it did back in the 2000s. Conversely and concerningly, negative-yielding government bonds, such as the German bund, offered very little offset to the equity market drop. Many analysts believe yields can only drop so far and that there is a lower bound where investors look elsewhere to store their cash. It is suggested the non-hedging behaviour of the bonds with negative rates is a reflection of being closer to that lower bound.
There is no direct alternative
Government bonds offer security, hedging and liquidity. Unfortunately, no other asset offers these qualities to the same levels. A government bond is described as risk-free because there would need to be almost inconceivable levels of economic stress for developed country governments to default on their borrowings. Although governments are currently borrowing at unprecedented levels, there is still very little concern over default within the G12 countries. The guaranteed capital return of these fixed-expiry securities is unmatched by other offerings. Cash held in a UK bank account is only provided protection of up to £85,000 through the Financial Services Compensation Scheme (FSCS) in the event of default and offers a lower yield. More secure cash depositories are costly and explain why bond holders are willing to accept a negative yield on their investments.
With regards to hedging, many investors have turned to alternatives to provide higher yields as well as downside protection. The traditional 60/40 portfolio (60% equity, 40% bonds) has been augmented over the years to include property, commodities and other alternative investment funds. Absolute return funds aim to provide a constant income regardless of the economic environment and gold has been known to rally much like Treasuries in a market crash. These assets offer further diversification to portfolios and are a rational alternative when partially allocating away from government bonds. There has been widespread interest across the industry and the assets under management are predicted to hold level this year at $10.74tn in defiance of the weaker market[viii]. Despite the enthusiasm for alternatives, investments in government bonds have stood strong. The bottom-line is that government bonds behave in a unique and desirable way. To provide but a few examples of how alternatives do not fill the same shoes; gold is highly volatile and does not offer the guaranteed return that bonds do at expiry; alternatives can use hedging through derivatives on the downside but at the cost of considerable illiquidity or expense; some alternative funds have appreciated in crises, much like government bonds, but often this feels like picking a needle out of a haystack.
Over the next economic cycle, holding government bonds could prove a drag to portfolio performance figures. As economies recover and interest rates creep upward, government bonds will depreciate, and returns may enter the red. If inflation were to return to markets, and the argument for it is noteworthy, bond performance would be hampered further. Yields would push higher to remain consistent on real-terms and bond values would deteriorate. Nevertheless, caution should be taken before insinuating that yields and interest rates can only go up. Many investors have lost out by following this mantra in recent years. Furthermore, it is never known when a negative shock might hit the economy, at which point government bonds prove their worth. There is sufficient justification for investment managers to look elsewhere for income, but for now, while at positive yields, government bonds will continue to be a core holding in almost all portfolios. That said, should Treasury yields turn negative in the future, the game may change entirely.
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