Don’t Fear Government Bonds in Multi-Asset Portfolios

29 May 2020

4 min read

Sharat Kotikalpudi| Director of Quantitative Research—Multi-Asset Solutions

Today’s bond yields are extremely low, and some multi-asset investors may be struggling to rationalize exposure to interest-rate driven assets such as government bonds. But past experience suggests that they can still be effective diversifiers over the near term, even at low yield levels.

As the world battles the COVID-19 pandemic, government bond yields have tumbled. US 10-year Treasury yields fell below 1% for the first time in history in early March, settling in the 60–70 basis-point range. 10-year UK gilt yields have hovered around historical lows of about 20 basis points. Meanwhile, 10-year yields in Japan and Germany have stayed at zero/negative levels, where they’ve been for a few years now.

Given the bleak yield landscape—and the Federal Reserve’s repeated rejections of resorting to negative interest rates—it’s no shock that some investors are questioning the idea of maintaining interest-rate exposure as a diversifier in multi-asset portfolios. After all, how much more can government bonds really have left? And can they still be relied on to diversify against risk assets?

The Low-Interest-Rate Experience: Japan and Germany

While it’s true that government bond returns aren’t likely to be impressive at their current yield levels, our research suggests they may still be effective diversifiers when used tactically.

US Treasury yields don’t have much experience in ultra-low-yield environments: the 10-year Treasury yield has never been negative, and we think negative rates are unlikely. German bunds and Japanese government bonds (JGBs), however, have seen extremely low or sub-zero rates for a few years now.

Since 2010, 10-year JGB yields have been below 1% on more than 2,200 different days. That total includes 475 days with sub-zero yields. German Bund yields dropped below 1% in the second half of 2014, and they’ve remained in negative territory since March 2019.

Across this entire data set—over 5,000 days of very low interest rates—Japanese and German government bond prices mostly moved in the opposite direction from stock prices. So, directionally, they did what they were expected to do—they provided diversification, as illustrated by negative correlations (Display).

Bonds Remain Effective Diversifiers in Low-Yield Environments

Government Effective to Stocks by Level of 10-Year Yield

Daily data from January 1, 2010, through April 30, 2020
Stocks are represented by the MSCI Japan Index and MSCI Germany Index excess returns hedged to US dollars. Fixed income is represented by the Bloomberg Barclays Global Treasury Japan Index and the Bloomberg Barclays Global Treasury Germany Index.
Source: Bloomberg Barclays, MSCI, Global Financial Data and AllianceBernstein (AB)

Yes, Bond Yields Are Low—but Don’t Forget About the Slope

How can duration remain an effective diversifier against risk-asset exposure, even when bond yields are ultra-low or even negative? As it turns out, the level of yield on government bonds isn’t an effective predictor of short-term future returns. But the slope of the yield curve is.

The key is carry, the currency-hedged excess return versus cash from longer-term bonds over time—all else remaining equal. The value of carry is defined by the difference between longer-maturity yields and shorter-term cash rates—the slope of the yield curve.

As measured by the difference between 10-year yields and three-month rates, the slope of major developed-market government bonds was about 40 basis points in mid-May (Display). That’s below average, but still meaningful. The US Treasury yield-curve slope was about 60 basis points.

With positive yield-curve slopes, government bonds still have the potential to deliver modest returns and provide diversification against risk assets in multi-asset portfolios. So, in our view, carrying duration exposure on a tactical basis still makes a lot of sense.

Yield-Curve Slopes Offer Carry Potential

Three-Month/10-Year Government-Bond Yield-Curve Slope

Through May 18, 2020
Global yield curve represented by bond market capitalization-weighted average of developed-market government bond yields
Source: Bloomberg Barclays and AllianceBernstein (AB)

Government Bond and Equity Positioning: Hand in Hand

From an intuitive standpoint, government bonds have been effective diversifiers for equities in environments where investors’ primary concern is centered around the economic growth outlook. Duration has not been effective in that role when investors fear inflation risk, but inflation risk isn’t prominent right now.

Based on our current assessment, multi-asset portfolios that are tactically neutral or overweight to equities should consider a modest overweight to duration as a counterbalance. We think the environment—poor growth, low inflation and falling yields—supports it, and central banks seem committed to keeping rates down. We also feel that attractive yield spreads in fixed-income credit merit an overweight and can enhance returns.

Multi-asset investing requires a broad tool kit, including beta diversifiers like duration, though diversification isn’t the only way to defend against drawdowns. Other techniques, such as tactical shifts and options can also be effective (in combination or alone) in different conditions.

While no tool is effective in every environment, the Japanese and German experiences in very low interest-rate scenarios provide evidence that low yield levels alone aren’t necessarily a reason for multi-asset investors to ignore government bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Author

Sharat Kotikalpudi

Sharat Kotikalpudi is the Director of Quantitative Research in the Multi-Asset Solutions Group at AB, specializing in systematic macro strategies; he leads the group's quantitative research in directional and cross-sectional strategies across developed and emerging markets within equity futures, currencies, rates and commodities. He is also a Portfolio Manager of AB Systematic Macro. Kotikalpudi joined AB in 2010 as a quantitative analyst on the Dynamic Asset Allocation team, where he helped to design and develop the quantitative toolset used in the group’s asset-allocation strategies. He holds a BE in electronics and communication engineering from the Manipal Institute of Technology, India, an MA in mathematics of finance from Columbia University and a PGDM from the Indian Institute of Management Calcutta. Location: New York

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