The diversification benefits of government bonds
We advocate a strategic allocation to government bonds, despite their low potential returns, as a buffer against equity market selloffs. Richard explains.
Government bonds have provided a buffer against equity market selloffs for much of the post-crisis period. Bond prices have tended to go up when stock prices have gone down and vice versa, displaying a negative correlation on average.
This pattern played out again early last week when North Korea-related geopolitical concerns escalated — a timely reminder to diversify equity risk via an allocation to government bonds, in our view. This is especially true at a time when some investors have lost faith in this principle following several notable episodes in recent years when stock and bond prices moved together. See the annotated spikes in the chart below.
Rapidly rising rates undermined confidence in equity markets in those episodes, which included the “taper tantrum” of 2013 in response to Federal Reserve hints about tapering and the 2015 spike in German bond yields. The result: Bond allocations amplified rather than reduced portfolio losses. Fears of similar upsets appear to be holding back investment flows into government bonds, while thirst for income has boosted other fixed income assets such as credit. A fear of rates rising from historically low levels also may be contributing.
Yet rates have reversed this year from their post-U.S. election surge, and market movements early last week highlight how government bonds can still offer portfolio diversification benefits few other assets can, in our view. Our analysis shows government bonds have provided positive returns during periods of significant equity declines, upholding their diversifying role. Of the 22 months since 2010 that featured negative U.S. equity returns, bonds notched positive returns in each month in which equities fell 2.5% or more. The one exception: during the taper tantrum. There are also periods when bonds and stocks both move up together. This has generally occurred when expectations of increased central bank support for financial markets lift both assets. Case in point — after the European Central Bank (ECB) policy meeting this summer that quashed market expectations of an imminent ECB shift to normalize policy.
We do expect interest rates to rise, albeit at a very slow pace as U.S. and eurozone monetary policies gradually normalize. The implications: Expect low or negative returns for government bonds globally in the medium term. We favor stocks overall, but advocate strategic allocations to government bonds including TIPS for diversification purposes — even in the case where bonds underperform cash. We do not advocate large cash allocations, as cash dampens but does not diversify equity risk. Read more market insights in my Weekly Commentary.
Listen to Richard Turnill and Jeff Rosenberg talk about BlackRock’s midyear investment outlook on the inaugural episode of our podcast, The Bid.
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Originally published at www.blackrockblog.com on September 5, 2017.