Global bond yields hover near all-time lows. In the United States, a 10-year Treasury note yields less than 2%. In Europe and Japan, the bond markets have tumbled through the looking glass into a world of negative interest rates. About 40% of European government bonds yield less than 0%. In Japan, the figure is 70%.
The prospect of low to negative returns on government bonds has raised doubts about their value. Why hold an asset that yields almost nothing (or less than nothing)? Why take on any price volatility if you can stash cash in a safe?
The doubts are understandable. Return is the most salient feature of any asset class, and it’s hard to get happy about 0%. In an asset allocation framework, however, return has different dimensions. And by one critical measure in mean-variance optimization, which weighs both return and risk, high-quality government bonds have never been more valuable.
Building a multi-asset-class portfolio appropriate to a given goal and risk preference depends, primarily, on the following three characteristics of each asset:
- its expected return
- the expected volatility of those returns
- the correlation of the asset’s return with those of other assets (i.e., its covariance)
The low yields of U.S. Treasury bonds imply that their expected returns are exceedingly modest. We expect the volatility of government bonds to remain consistent with recent trends. But government bonds’ correlation with stocks suggests that their diversification power has never been stronger. And under some simple assumptions, this higher diversification value offsets the lower expected returns on government bonds. Period.
The chart below displays the correlation between monthly percentage changes in the price of the S&P 500 Index and changes in the yield of the 10-year U.S. Treasury note. The blue line displays correlations over rolling five-year periods. The data come courtesy of Nobel laureate Robert Shiller.
Since 1871—yes, almost back to the American Civil War—the correlation between changes in stock prices and changes in bond yields has averaged 0%. Over the past five years, the correlation has averaged –0.6%, the lowest in U.S. history.
In portfolio construction, assets with a strongly negative correlation to other portfolio assets are the Holy Grail. They rally when other assets retreat. This relationship was especially visible at the start of 2016. The U.S. dollar is the world’s reserve currency, making U.S. Treasuries the destination of choice in a flight to quality. And when global stock prices tumbled earlier this year, intermediate-term Treasury bonds rallied.
Treasury yields are low, but their diversification has never been higher
Correlation between U.S. stocks and long-term U.S. Treasury bonds, 1871-2016
Data: Shiller, correlation between monthly percentage changes in S&P 500 and inverse monthly difference in 10-year yield
What explains the unusually negative correlations? The correlation between stocks and bonds changes through time. It has tended to rise in periods of higher-than-expected inflation, as in the stag flationary late 1970s and early 1980s, when both stocks and bonds retreated. Stock- bond correlations in the United States have tended to fall in periods of slow growth and deflationary fears, the environment that has prevailed over the past few years. Our outlook suggests that such conditions are likely to persist in the years ahead.
My colleague Fran Kinniry has called high-quality bonds1 the Rodney Dangerfield of investments. Like the late comedian, they get no respect. And as yields have crept lower, their status has declined. But that drop in status is undeserved. Successful portfolio construction is not just about return. It’s also about diversification. And at the moment, the data indicate that no asset boasts more potent diversification power—and more potential to protect a portfolio in a stock market downturn—than U.S. Treasury bonds.
1 A bond whose credit quality is considered to be among the highest by independent bond- rating agencies.