While falling bond yields are positive for immediate bond returns, they do not bode well for future bond returns. Falling yields have led to lower subsequent returns. A 10-year U.S. Treasury bond in 1990 generated double the total return over the next 10 years compared with a 10-year U.S. Treasury bond from 2010 to now.
Beside the return component, a crucial reason to hold bonds was to diversify equities, especially during deep equity market drawdowns like those experienced during corrections and bear markets. Looking at the largest equity drawdowns over the last 40 years across four major markets and sovereign bond responses to these, we see three distinct periods: an inflation era (early 1980s), a golden era (up to mid-1998), and a low-rate era.
When inflation risks drove equity sell-offs, bonds tended to sell off, too. During the golden era, the fears of investors shifted more to growth risks than inflation risks, so bonds nicely diversified stocks in equity market sell-offs. In a low-rate era, the diversification benefit of bonds has greatly decreased. One way to measure this is via the optimal hedge ratio: What is the ratio of the equity market decline to the bond return during a drawdown? While in the 1990s a long position in sovereign bonds three times as large as equities was required to offset equity drawdowns, this ratio has increased to 20 times during the low-rate era of the last couple of years.
What alternatives are there for investors for this diversification function? "Long volatility" strategies in general — those strategies that do well when volatility rises — will likely become a standard part of investors' toolboxes. These strategies can include trend following, dynamic risk hedging using futures, or option overlay strategies to manage these downside risks.