With central banks anchoring official rates at historic low levels, investors are understandably concerned that today's low government bond yields will limit downside protection going forward. And they're worried that government bonds will have less room to rally during risk-off periods and that returns will be curtailed.
But the experience that we've seen over time shows that low or even negative yields don't eliminate that buffer that's provided by holding duration, or government bonds.
For example, during the most recent downturn in the first quarter of 2020, at a time when German Bund yields on 10-year bonds were a roughly negative 50 basis points, German bond returns were up about 2% during the first quarter. That compares with the euro high-yield market, which was down about 15% over the same period.
That's one crisis period, but we might be in store for these low yields for an extended period of time. And that has investors worried that returns might be very muted going forward. But here's where the Japan experience could guide us.
Low yields in Japan have not necessarily translated into ultralow returns. In 11 of the past 12 years, the yield on the 10-year JGB has been less than 1%.
But in contrast, the returns on Japanese government bonds have actually been twice as much as the yield over that same period. And in fact, they were rarely as low as the starting yield level.
That argues you should hang on to that government bond allocation, which provides essential defense during those periods of heightened volatility and sell-offs of risk assets.