As concerns about a COVID-19 induced market crisis have receded, asset owners are once again wrestling with questions that became familiar in the post-global financial crisis environment. In a world of historically low interest rates, what place do sovereign bonds have in a portfolio? Is their return outlook finally brightening, and will they remain an effective offset against equity market shocks? What are the alternatives to sovereign bond allocations, and how should investors go about identifying suitable solutions?
The perceived role of sovereign bonds in asset allocation has evolved over the past 40 years during the secular bull market in fixed income. In 1990, with the U.S. 10-year yield around 8%, bonds offered a source of steady income that could meet many investors' overall portfolio return targets. But as interest rates continued to fall, so did expected bond returns. To meet performance targets, asset allocation models progressively pushed investors to increase their equity exposure at the expense of greater overall portfolio risk and, specifically, vulnerability to stock market shocks. Over the past 20 years, however, bonds have provided a reliable hedge against equity market drawdowns, and bond allocations have come to be valued for their risk reduction benefits if no longer for their expected returns.
But in 2021, the outlook for bonds now seems grim in both regards. With respect to returns, while the U.S. 10-year Treasury yield has risen a full point from its 2020 nadir, at only 1.5% it remains not far off pre-COVID-19 lows, and the real yield is negative. Moreover, while signs of reflation have sparked hopes of higher yields, capital losses on existing bond allocations would test the mettle of long-term fixed income investors, offsetting benefits from more attractive reinvestment opportunities that would take time to accrue. On the other hand, if the economy falters and rates fall further, then — despite another unexpected tailwind from rising bond prices — questions about the role of fixed income would become all the more pressing in an even more anemic yield environment.
What's more, investors should not assume that bonds will continue to provide strong equity risk reduction. Such benefits haven't always been the norm — prior to the 2000s (Figure 1), bond and stock price correlations were positive for nearly three decades — and recently, bonds and cap-weighted equity indexes sold off together amid concerns about re-emergent inflation and diminished prospects for large-cap stocks that benefited from COVID-19-driven lockdowns and the need to work from home. In addition, if the economy were to fade, then central bank policy measures might restrict the ability of bond prices to offset equity market drawdowns, similar to the impact of yield curve controls in Japan.