It’s no secret that the yields available today on quality bonds such as Treasuries, Agencies and Municipals are miserly. I have recently been asked by a number of investors whether they should continue to hold or to purchase such bonds — or shift the money into higher-income assets such as high-yield bonds or preferred stocks. I believe quality investment-grade fixed income, even at today’s low yields, still plays an important role in a well-diversified portfolio.
To explain why, let me briefly describe my fixed-income philosophy. Bonds generate some income for the portfolio, but the risk-management qualities of short-term, high-quality government bonds (including munis) are even more important. These assets reduce total portfolio volatility and provide liquidity and stability.
This is, in part, a behavioral story: Historically, investors have been well compensated for taking risk in equities — from January 1926 to December 2019, the equity risk premium (S&P 500 Index versus one-month Treasuries) for U.S. stocks was approximately 7.0 percent. But equities are volatile; too many panicky investors dump their stocks in turbulent times and don’t earn the equity premium. Short-term, high-quality bonds can smooth the ride and keep investors in their seats.
Instead of looking at an asset class such as bonds in isolation, we examine what it contributes (or adds) to a diversified portfolio. Short-term, high-quality bonds are typically negatively correlated with equities, which makes them a valuable hedge. For instance, during the 15 years from September 2004 to December 2019, the correlation between 5-Year Treasury Notes and the S&P 500 Index was –0.32.By contrast, during the same time frame, high-yield bonds, as represented by the Bloomberg Barclays High Yield Corporate Bond Index, had a positive 0.72 correlation with equities, which implies that they behave much like stocks and do not provide the same portfolio diversification benefit as short-term Treasuries. This makes intuitive sense: as with stocks, high-yield bonds benefit from a strengthening economy, while Treasuries tend to shine when growth weakens or as a safe haven in a time of crisis.
To better understand the risk mitigation quality of high-grade government bonds, let’s examine how different asset classes behaved during the violent storm of the 2008 global financial crisis. During the 16 months of market carnage from November 2007 to March 2009, Treasuries demonstrated resilience during the turmoil. High-yield bonds slumped and “bond proxies,” including preferred stocks and MLPs, provided none of the portfolio diversification benefits of short- or medium-term U.S. Treasuries. Disciplined, level-headed investors should tap into the liquidity of government paper in their portfolios at times like this to purchase stocks, REITs and other bombed-out asset classes at bargain prices.
In short, we cannot do anything about the very low yields on offer today for short-term, high-quality government bonds. At the same time, we still should not abandon these assets, which play a valuable risk-management role by balancing riskier investments such as stocks, REITs and commodities by lowering total portfolio volatility.
Ashvin Viswanathan is director of quantitative strategy at Gerstein Fisher.