Commentary: The unbundling of government bonds

A sharp drop in growth and inflation expectations combined with a sharp rise in fear and central bank buying has pushed government bond yields to historical lows. Traditionally, government bonds helped play multiple roles in a portfolio: generate income, diversify equity risk and help with liability-hedging strategies.

With yields where they are, can government bonds play the same role in a portfolio? We don't think so. Rather than going to government bonds as a one-stop shop for these three roles, we think investors will have to look at specialized solutions for each role.

Bond returns have an income component from the coupon and a capital gain component from yield changes. Income returns come from the coupon and coupon rates have moved lower with yields, so income is hard to find — especially income that might compensate for long-term inflation.

When yield curves are upward sloping and stable, investors in longer-term bonds can benefit from a positive roll-return down the yield curve as the bonds continues to mature. With yield curves relatively flat or inverted, roll-return is hard to come by.

If you consider capital gains from yield curve changes, at current yield levels of 0.5% for a U.S. 10-year Treasury bond, yields would need to fall by 45 basis points to generate a one-year total return of 5%, which is what bond investors were used to realizing in the past. This would push the U.S. Treasury 10-year bond yield to close to zero. But what then? If you go to zero or negative, a negative coupon rate would serve as a drag on returns that would need to be overcome, so the yields would have to go perpetually lower and more negative to continue generating positive returns.

Assuming a future of inflation and not deflation, it is hard to justify negative long-term bond yields as bond investors expect to be compensated for inflation with a risk premium. This should impose a floor on long-term bond yields. However, demand caused by monetary stimulus through measures like quantitative easing are able to push bond yields into negative territory for much longer than investors would have expected. As a result, to generate income, alternatives like taking on more credit risk, taking on equity risk or writing options may have to serve as a substitute for this traditional role of government bonds.

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.

Many investors that hold sovereign bonds hold them because they are required to by regulators or to hedge the effect changes in interest rates have on their future liabilities. Both pension funds and insurance companies are common hedgers and these approaches can broadly be referred to as liability-driven investing strategies. When sovereign bond yields are positive, hedging reduces risk and is expected to add return. With sovereign bond yields falling to or through zero, the return generation contribution is largely lost. To the extent that leverage is employed, the expected return of hedging will depend on the shape of the yield curve. The yield curve has been positively sloped historically and even recently in countries with negative nominal yields like Germany or Japan.

LDI isn't broken with negative yields, but it does become harder. This is why CDI, or cash-flow driven investing is rising in popularity. It relies on segmenting a portfolio into the part that hedges long-term liabilities but uses credit to generate income to cover short-term cash flow needs as they arise. This requires prudent oversight as even high-quality credit spreads can be sensitive to equity market drawdowns.

Government bonds used to serve many functions. Those functions might need to be unbundled with specialized solutions serving those roles. To generate income when coupons are close to zero will likely require focusing on credit, equities or option strategies. Government bonds can still play a role in diversifying equities, but their ability to do so — especially during equity market drawdowns — will likely be significantly dampened in the future. More explicit risk management strategies will likely need to substitute for government bonds. Finally, from a liability-hedging perspective, the role of bonds has not changed; though, from a return perspective, the opportunity cost of hedging with sovereign bonds has increased sharply. An approach that prudently incorporates more credit risk — like CDI — could become more popular over time.

Brian Jacobsen, Milwaukee; Kevin Kneafsey, San Francisco; and Matthias Scheiber, London, are portfolio managers at Wells Fargo Asset Management. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.