Big shoes to fill: Rethinking defensive asset allocations after a 40-year bull market in Treasury bonds

U.S. Treasury bonds are not likely to repeat their spectacular performance as income-producing risk reducers in portfolios of the past four decades. While bonds still have an important role to play in some settings (e.g., liability hedging for retirement plans), we believe investors should look at alternatives for diversification, including inflation-protected securities, gold, defensive currencies and stocks and option protection. However, we believe that no other asset class alone can fulfil all the functions that bonds played. We think it’s prudent for investors to consider a balanced combination of the bond alternatives we identify here.

A great run for bonds

Over the last 40 years, Treasury bonds have been a boon to investors. With 10-year Treasury yields starting the 1980s above 10% and falling below 1% in 2020, U.S. bonds generated a remarkable compound return of 10% annualised.¹ What’s more, they usually performed well when needed most. In times of equity market distress, bond prices soared as yields sank, particularly when the Fed was able to cut policy rates by hundreds of basis points.

Unlike in prior economic cycles, bond yields don’t have the room to fall by hundreds of basis points in a future recession as the Fed’s policy rate is close to a (soft) lower bound of zero. Although U.S. short rates could move into negative terrain like in Switzerland or the eurozone, the Fed seems reluctant to go down that path because it is wary of the adverse side effects on money market funds and bank profitability.

So, with 10-year yields around 0.7%, as of 1 October 2020, the leeway for them to drop is much more limited than in previous recessions. Even if - and that’s a big if - U.S. 10-year yields sank as low as their German equivalents did in 2020 (to -0.8%), we are talking about 150 basis points of yield decline. In reality, it’s more likely to be less than 100 basis points from current levels. By comparison, the average decline in the 10-year yield during previous recessions since 1980 was 260 basis points² (excluding the current Covid-19 downturn). Therefore, the risk-reward trade-off of using Treasuries to diversify equity risk looks less favourable than in past cycles.

Don’t get me wrong. Bonds are still a core liquid asset that play a risk management role for investors with long-duration liabilities. They are also one of the few assets that can effectively hedge deflation risk. We think bonds will maintain a negative correlation with equities and directionally buffer large declines in stock markets. However, expected returns on bonds are low given starting yields today - and, despite convexity, the magnitude of bond price increases in future stock market drawdowns will likely be more limited in future.

Complement bonds with other diversifying assets

For investors concerned with downside risk, it makes sense not to solely rely on bonds as stock market diversifiers. Let’s look at some of the potential alternatives to government bonds. To be an effective counterbalance to equity risk, an exposure either needs to have much lower volatility than, or a negative correlation with, the stock market. Further, given that physical diversifying exposures can crowd out allocations to growth assets, unfunded exposures should also be given serious consideration.

• Cash
  Cash offers nominal stability and diversifies equity risk by virtue of having minimal return volatility. However, cash almost certainly will have negative real return for an extended period as central banks keep policy rates below the inflation rate to support the economic recovery. Cash rates could still go outright negative in nominal terms. In our view, cash is an unattractive bond alternative.
  
  
• Gold
  The price of gold often rises when the opportunity cost of holding it, as measured by the real interest rate, is low. Unlike bonds, the price upside for gold is not limited. In addition, the gold market is sufficiently large for investors to make significant allocations to. Gold could be particularly attractive in an inflationary scenario with financial repression. In such an outcome, policymakers keep nominal bond yields low through continued asset purchases while engineering a rise in inflation.
  
  The main disadvantage of gold is that it does not produce an income. Moreover, its market value is often driven by investor beliefs and supply/demand imbalances rather than its intrinsic qualities. Its industrial use is dwarfed by investment allocations, making it potentially susceptible to swings in investor sentiment. We believe gold can play a diversifying role in portfolios, although it should not be seen as the one replacement for bonds. Gold-mining companies and other raw materials producers are a way of securing reserves in the ground rather than the finished commodity.
  
  
• Treasury Inflation-Protected Securities (TIPS)
  Like gold, TIPS will likely do well in an inflationary scenario that could be harmful to other asset classes (including equities). We believe that inflation rates discounted in TIPS are still low enough, at around 1.6% for the next 10 years, to make the asset class an attractive inflation hedge and a worthwhile alternative to conventional bonds.
  
  
• Long U.S. Treasuries futures / short Euro Bund futures

  One creative way of obtaining the downside hedging properties of Treasuries while lessening the adverse effect of a potential spike in global yields is to establish a long Treasury future/short Bund future position. At around -0.50% yield for the 10-year maturity, German government bond yields are arguably even closer to their floor than their U.S. equivalents. In a risk-off scenario, Treasuries would have more room to rally than Bunds while potentially moving more in sync in a rising rate environment. If that is indeed the case, the exposure creates a welcome asymmetry of protecting in a bad state of the world and being neutral otherwise.
  

• Defensive currencies
  With developed-market interest rates all in lockstep and close to zero, currency markets could be the release valve for macroeconomic imbalances and major market events. Some currencies like the Japanese yen often rally when risk assets sink, i.e., they are defensive currencies. We think that holding defensive currencies against those with the opposite behaviour, for example the Australian dollar, is a good hedge for equity risk. Currency exposures do not require upfront funding. That also applies to return-seeking strategies that have a risk premium exposure with low correlation to stock markets.
  
  
• Defensive stocks
  Another way of lowering equity risk while maintaining some upside is to create baskets of defensive stocks that had stable positive dividend income and/or stable cash flows through prior recessions. The main drawback is that such a strategy still has some positive correlation to the overall stock market. However, its lower downside risk could reduce the need for diversifying asset classes.
  
  
• Equity options
  Finally, index put options are the most direct downside protection for equity market exposure. This is akin to buying insurance where the investor pays a premium for protecting against an adverse outcome. Using option protection on some portion of equity exposure may allow for retaining a higher allocation to equity than otherwise possible.

The bottom line

While we emphasise that bonds still have a role to play as a risk-reducer and deflation hedge, we believe that they will not be as powerful a counterweight to equity risk as in the past. It is time to look at some worthwhile alternatives to nominal Treasuries: inflation-linked bonds, gold, defensive equities and currencies and equity options, to name a few. With short-term interest rates likely to stay close to zero for an extended period, investors might want to consider using leverage and unfunded exposures to enhance their portfolio diversification. It is unlikely that any single exposure will perform as well as bonds have done in that function. Therefore, we believe investors will need to find a balanced combination of bond alternatives such as we have outlined here, else accept that portfolios are likely to experience greater downside risks than have been the case prior.