How I learned to stop worrying and love the bond

Low yields, potential volatility: Why even hold bonds? Russ explains the crucial role they still play in a portfolio.

U.S. Treasuries are not cheap. At roughly 2%, nominal yields are less than a third of the 60-year average of 6%, according to Bloomberg data. Although they are not as egregiously expensive as 10-year Swiss government bonds—currently trading at a yield of negative 0.25%—U.S. bonds are offering a relatively paltry real return, even after adjusting for low inflation.

Moreover, government bonds are potentially more volatile. For now, that volatility is being suppressed by the lethargic pace of the Federal Reserve’s (Fed’s) tightening cycle. But there is plenty of risk embedded in traditionally safe government bonds.

Low coupon rates mean that investors get almost all of their cash flow at maturity. This pushes up a bond’s duration or rate sensitivity. In practice, a 10-year bond yielding 2% is more rate sensitive than a 10-year bond yielding 6%. If rates start to rise, bond volatility will be exacerbated by higher durations. Another way of looking at this: With a 2% coupon, a relatively small rate move will wipe out a year’s worth of interest.

But despite high prices and the potential for more volatility, there is still a very good reason to continue to own government bonds: diversification.

Use bonds as a hedge

While government bonds currently produce little in the way of income, U.S. Treasuries have been providing a hedge against equity risk. Since the financial crisis, but really since the bursting of the tech bubble, bonds have been more likely to move in the opposite direction to stocks. This trend has only intensified since the financial crisis.

Why should this be the case and is it likely to continue? Looking back over the past 25 years, a period of low and stable inflation, stock/bond correlation has generally moved in tandem with monetary policy, as measured by the effective federal funds rate. In the 1990s, when investors were more worried about inflation and an aggressive Fed, the correlation between stocks and bonds tended to be positive. However, as the Fed has increasingly pushed the boundary of monetary accommodation correlations have fallen.

What history tells us

Over the past quarter century the level of the fed funds rate has explained nearly 50% of the variation in stock/bond correlations, according to Bloomberg data. Take a look at the chart below. During this period, when the policy rate was above 2%, the average correlation was close to zero. In periods when the fed funds rate has been below 2%, as has been the case since late ’08, the average correlation has been roughly -0.25. (A correlation of 1 means two asset classes move in lockstep. A negative correlation means they move in opposite directions. A zero correlation means their movements are unrelated.) As long as the Fed remains reluctant to raise rates, history would suggest that the correlation between stocks and bonds is likely to remain negative.

Stock Bond Correlation

A negative stock/bond correlation is important for managing portfolio volatility. Portfolio risk is not simply the sum of the volatility of the individual assets; it is also influenced by the correlation between those assets. To the extent that longer-term government bonds provide diversification—a scenario more likely in an environment in which the policy rate is low—bonds have a role to play in a portfolio, even if they are expensive and more volatile.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to maket principal and interest payments.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

USR-9190