Treasury bonds remaining popular despite low yields

Despite the decline in U.S. Treasury bond yields since the outbreak of the COVID-19 pandemic early this year, many institutional investors remain committed to the government bonds because they still offer liquidity and safety.

However, given ongoing concern about high equity valuations, ultralow interest rates, uncertain inflation moves and difficult market conditions, asset owners increasingly are implementing or considering making tactical changes to their asset allocations and some are turning to explicit hedging strategies to better protect their portfolios on the downside.

The $45.6 billion Public School and Education Employee Retirement Systems of Missouri, Jefferson City, for example, increased the fund's allocation to U.S. Treasuries to 20% from 16% this year even though "Treasuries are painful to hold right now. We need them for safety and liquidity," CIO Craig Husting said in an interview.

He said that with the yield on a 10-year U.S. Treasury bond under 1%, "we are sacrificing yield for the protection Treasuries offer."

The 4-percentage-point increase in the U.S. Treasury bond allocation was funded by the elimination of Treasury inflation-protected securities because "in a low-interest-rate environment, we preferred the flexibility to opportunistically invest in TIPS instead of maintaining a static allocation," Mr. Husting said. He said that a 9% allocation to public credit also was zeroed out because "we wanted a cleaner, less risky fixed-income strategy."

By way of seeking higher returns to make up for low U.S. Treasury bond yields, the plan continues to build out its private market portfolios.

Mr. Husting said the allocation to private credit was increased by 2 percentage points to 8%; the private equity target was raised to 16% from 12%; and the real estate portfolio was increased to 11% from 9%.

"We feel pretty good about the portfolio, but it's a tough environment to get to where we want to go," said Mr. Husting, noting that the systems' assumed rate of return is 7.5%. He added, "We will lower it if necessary."

Investment staff of the State of Wisconsin Investment Board, Madison, on the other hand, are reevaluating the use of U.S. Treasury bonds, said Brian Hellmer, managing director, global public market strategies, during an Oct. 19 panel discussion at Pensions & Investments' WorldPensionSummit.

U.S. Treasuries "traditionally provided ... two functions within the portfolio — some hedging qualities and also some return generation," he said, adding that the asset class isn't generating returns now.

"It's truly an insurance policy that has a cost without producing at least real return to the degree that we believe that it's a structural immediate- to long-term challenge for us," Mr. Hellmer said.

The investment board needs to "really rethink" the exposure the funds have to U.S. Treasuries, how they're used in the portfolio and "what the risks are of moving fully away from Treasuries," he said.

"It may seem counterintuitive given that we've come through this period of heightened volatility and uncertainty that we would walk away from what most people consider the safest asset class, but maybe that's exactly the right thing to be thinking about doing given how the pricing has created this expectation of literally no real return within that asset class." he said.

Still, Mr. Hellmer said, "the way the market has responded (to the pandemic has) created sectoral and regional opportunities. We found ourselves looking away from the U.S. to other developed markets, emerging markets."

The board manages a total of $126.3 billion of which $112.5 billion is in the Wisconsin Retirement System. Like the Missouri and Wisconsin funds, the investment management industry and the investors it serves are evaluating the future of U.S. Treasury bonds as a core allocation and hedge against equity risk, observers said.

"The role of U.S. Treasury bonds over the last decade was protection. Their role is purely to reduce equity risk in portfolios," which did happen when equity returns fell sharply earlier this year in response to the COVID-19 pandemic, said Adam M. Levine, investment director for the solutions group of Aberdeen Standard Investments.

"The question now is whether U.S. Treasuries will provide a sufficient level of protection from an equity crash if the Treasury curve is flat and interest rates are negative," Mr. Levine said.

Aberdeen Standard managed $562.9 billion as of June 30.

Yields on 30-year U.S. Treasury bonds fell 133.6 basis points to 0.995% on March 9 from 2.331% on Jan. 1, but recovered somewhat by Oct. 28 to 1.556%.

Some asset owners are not waiting for the answer to Mr. Levine's question, given current yields, and are shifting portfolio weightings to invest in strategies that include commodities, especially gold and other precious metals, and TIPS to reduce inflation risk, sources said.

Others, particularly liability-driven corporate defined benefit plan sponsors, are diversifying their fixed-income portfolios away from long-duration government bonds by investing in more exotic, better-returning fixed-income securities including collateralized bond obligations and emerging market debt. Corporate funds also are turning to more illiquid strategies such as securitized products including mortgages, leveraged loans and private market debt, sources said.

Investment managers and consultants said they also are seeing a rise in the number of asset owners employing explicit hedging strategies including equity-put options and other derivative overlays; actively managed volatility strategies; and risk-mitigation approaches.

U.S. Treasury bonds have been and remain a mainstay for the $7.6 billion defined benefit plan of Textron Inc., Providence, R.I., but the investment team added risk-offset strategies this year given low yields.

Treasuries "have always been the go-to asset for risk management. They are the instrument with (an) AAA credit rating, ample liquidity and more often than not, perform well when equities don't," Charles Van Vleet, CIO and assistant treasurer, said in an email.

Textron's team is sticking with U.S. Treasury bonds as "our primary risk-off investment. I will bet you dollar-for-donuts that if the S&P is down 20% tomorrow, the 10-year UST, which yields 0.8%, will go to zero and the price will be up 8 points. Good return for an offset investment," he said.

Mr. Van Vleet admitted that his team is concerned that U.S. Treasury bonds "will work with less and less efficacy particularly if the S&P downturn is accompanied by a fiscal-deficit-induced surge in inflation fear."

To hedge that concern, the Textron team increased investment in two risk-offset strategies, he said.

The first is a basket of risk-off currency pairs that are long the U.S. dollar, the yen and the Swiss franc and short the euro, Norwegian kroner and Australian dollar.

"This basket of futures has traditionally been carry-neutral but always positive returning in risk-off environments. With rates at zero nearly worldwide, we have recently added gold futures to the long side," Mr. Van Vleet said.

The second risk-offset strategy invests in companies with "inelastic demand" and Textron has recently been investing in real estate including data centers, life science and cold storage facilities, Mr. Van Vleet said.

"These investments are available in the public REIT market or even better, in the pre-IPO private REIT market. The key, at all times, is to own things with pricing power and inelastic demand," Mr. Van Vleet said.

Many asset owners hesitated to take action to protect their portfolios, but sources noted that the pace of investment and allocation changes is quickening.

In the first half of the year, "it was tough for investors to get decisions made," said John Delaney, senior director-investments and portfolio manager based in the Philadelphia office of investment consultant Willis Towers Watson PLC.

"Over the last six weeks, more investment decisions were made, especially by corporate plans, and we've been having more conversations about asset class changes with clients," Mr. Delaney said.

Investment staff of the $155.2 billion Teacher Retirement System of the State of Texas, Austin, watched the impact of the pandemic on interest rates and had to make a decision about its 16% allocation to U.S. Treasury bonds.

Texas Teachers' CIO Jase Auby said that as interest rates fell early in the year, the investment team had to evaluate "the future hedging role of U.S. Treasuries in our portfolio."

"U.S. Treasury yields are near their all-time lows and yields do not seem to have much further to fall, however, we continue to believe that U.S. Treasuries will provide a hedge to our portfolio during a large equity market drawdown," Mr. Auby said in an email.

"An additional equity risk mitigator is our effort to diversify away from equity by adding leverage to Texas Teachers' portfolio," he said. "This has enabled us to diversify into potentially lower-returning assets but hold more of them to compensate for the reduction in higher-returning equity."

TRS' interim and long-term policy target for leverage is -6% and the net leverage allocation is -4% (2% cash plus leverage).

Texas Teachers' smaller neighbor, the $2.9 billion City of Austin (Texas) Employees' Retirement System, made a tactical move in April to increase the target allocation to U.S. Treasury bonds to 12% from 8% as a portfolio hedge and to provide returns. Funding for the increase came at the expense of U.S. corporate credit, which was reduced to 4%. The move was a good one for COAERS, said David T. Veal, CIO, in an interview, given that the U.S. Treasury strategy, managed by Hoisington Investment Management Co., returned 24.5% year-to-date Sept. 30.

"Treasuries are the purest hedge during an equity downturn, which proved to be true earlier this year," Mr. Veal said, adding, "but then we began to think about the next crisis and what might be better."

Mr. Veal said his team added a 1% allocation each to gold futures and TIPS, which will help out if inflation picks up.