Investors in longer dated US Treasury bonds (“Treasury bonds”) lost almost 13.5% (in US dollars) when bond yields spiked in March this year. Looking forward, another threat, inflation, will likely erode investor returns as treasury bond yields trade below or close to zero.
Given this outlook, why would Pyrford International allocate 77% of the Nedgroup Investments Global Cautious Fund to sovereign bonds?
This article explores the defensive nature of US Treasury bonds compared to other traditional income assets and demonstrates how mid-short dated Treasury bonds have offered the best form of defence during equity markets slumps.
It concludes with how these bonds are a critical component to an active asset allocation strategy in a multi-asset portfolio.
Treasury bonds are defensive assets
Treasury bonds have traditionally formed the defensive component of a multi-asset investment portfolio. The logic for their inclusion is diversification. Treasury bonds are one of the few asset classes that have a negative correlation to equity markets, meaning when equity markets are up, the returns on these bonds tend to be down. The opposite is true when equity markets fall as Treasury prices tend to rise as investors seek refuge from market turmoil.
These bonds are held in portfolios not just to generate yield, but also to provide downside protection during periods of market turbulence. Combine this with high liquidity and transparent pricing, and these bonds can form a vital element to a multi-asset allocation strategy.
The chart below compares the correlation of global equities to income asset classes. These include different maturity Treasury bonds, corporate bonds, high yield bonds and property. What this chart shows is that in general, Treasury Bonds are negatively correlated with global equity markets, compared with other income asset classes.The chart below compares the correlation of global equities to income asset classes. These include different maturity Treasury bonds, corporate bonds, high yield bonds and property. What this chart shows is that in general, Treasury Bonds are negatively correlated with global equity markets, compared with other income asset classes.
Delving further into these correlations, we looked at how correlations of each of the income assets changed over rolling 1-year periods since 2005. The horizontal line measures the return of the equity markets while the vertical line measures the correlation of the asset class with equity markets.
The dots that fall in the bottom left quandrant show that when equity markets have drawdowns, Treaury bonds generated positive returns compared to other income producing asset classes. In contrast, when equity markets are rising, the return on other income producing assets (blue circle) tended to rise with equity markets, where as Treasury bond performance tends to lag with most of the dots fall below the line.
Global corporate bonds also experienced isolated periods of negative correlations when markets dipped and when markets rose. However, this prevalence is nowhere near the frequency of negative correlation for Treasury bonds with the majority occurring in a single period (Dot.com market collapse).
When we considered increasing the rolling periods to 3- and 5-years, the results don’t change. The chart below depicts the median (most commonly occurring) correlation coefficients to global equity markets and shows how the expected correlation results doesn’t change using longer periods. Treasury bonds still offer best downside protection when equity markets fall.
Looking closer at the variability, the below chart of the dispersion of 1-year returns, puts the correlation data into perspective. Treasury bonds, particularly shorter dated bonds, offer the best downside and persistent returns compares to other asset classes with the lowest dispersion about the average 1-year return (median) and lowest distance between the maximum and minimum 1-year return. This also places the current 1-year loss for longer dated Treasury bonds into perspective as one of the lowest 1-year returns over the past 20-years. Other income asset such as property and high yield bonds, however, have higher average returns, but much wider variances and larger drawdowns as shown by difference in the maximum and minimum returns.
But how do these asset income classes perform during specific periods of time when markets have slumped over the last year 10-years? Do Treasury Bonds continue to offer the strongest downside protection?
Downside protection during market slumps
The chart below plots the returns over periods of market slumps. This is a interesting table, because it demonstrates that short dated Treasury bonds can consistently deliver more defensive returns when equity markets were down. Other assets, however, had a drawdown which isn’t surprising as their correlations tend to increase during periods of crisis, which we saw in the previous dot plots.
These results are explained further by looking how the additional returns required by investors to hold a corporate bonds vs government bond increase during times of market distress. This ‘spread’ is charted in the diagram below and shows how during times of equity crisis investors demand higher rates of returns for holding for holding corporate credit. The implication is that selling the corporate bond at the height of the crisis in 2008, 2011 or more recently in March 2020, would have a locked in severe losses for investors.
What does this mean for constructing portfolios?
Not all income assets offer the downside protection when equity markets slump. Yes, they produce yield, but they can suffer drawdowns at times when equity markets slump, which is precisely the time a portfolio needs protection or the time you want to be buying riskier asset classes such as equity.
The investment horizon is important here however, and more so if you have a need to withdraw capital (i.e. require liquidity) or are unable to wait for a market recovery.
Treasury bonds play an important role in portfolio construction for Pyrford, the investment managers of the Nedgroup Investments Global Cautious Fund. It allows the active manager to rotate into higher risk assets such as equities efficiently during periods of market stress, with a very low risk of locking in losses on their defensive income assets.
This is evident in the Pyrford Global Absolute return strategy, which only allocates to high quality sovereign bonds (A-rated) and a portfolio of global equity stocks. Their performance is demonstrated in the chart below, where one can see that by avoiding the majority an equity drawdowns and following a disciplined process to allocate capital to equity when markets offered value, one can deliver a consistent return profile over time in excess of a cash plus 3%- benchmark using sovereign bonds.
In present markets, Pyrford currently holds a large position in short- to mid- dated sovereign bonds for the diversification and downside protections reasons discussed in this article. Unfortunately, the strategy is not going to make a lot of money, but it shouldn’t lose you a lot of money either. Combine this with a proven track-record of allocating to equities when markets have slumped in the past (2002, 2008, 2014 and 2021), this strategy can deliver a defensive kicker in an investor’s portfolio mix and provide significant capital preservation.
In conclusion, we are at a point in the cycle where asset classes are expensive, including sovereign bonds. However, sovereign bonds, on the short end, still provide capital protection better than other income producing assets. This becomes more apparent during market downturns. Combined with a proven asset allocation strategy, this positioning can provide an enhanced defence in an investor’s portfolio, which becomes more important, the shorter one’s investment horizon.