Core bonds still act as diversifiers in this low-rate environment, but investors in search of higher yields may need to add risk.

Investors have generally held bonds for two distinct reasons. They believe:

  1. Bonds can provide portfolio diversification benefits. Including core bonds in a multi-asset portfolio can help smooth performance over time and offer protection during market downturns. Put simply, bonds are generally expected to zig when stocks zag.
  2. Bonds can provide steady, reliable income that historically has been high enough to help clients achieve their financial goals.

But are bonds still a good investment in the current low-rate environment? Bond yields have been on a downward trend for more than four decades, compensating investors with handsome returns as bond prices rose and yields fell (see chart below). During the past decade, market participants repeatedly declared that bond yields had bottomed out—only to see them reach fresh lows. However, with many leading central banks having implemented zero or negative policy rates, the concern has grown that bond yields have little room left to fall. This has led some to question whether bonds can continue to perform their role as diversifiers within multi-asset portfolios.

For investors looking to maintain their current risk levels, we assess the diversification benefits of bonds (specifically, core bonds)1 in a long-term, multi-asset portfolio. For investors willing to accept more risk, we discuss how a broader suite of yield opportunities can help address lower expected returns and income from core bonds in what is likely to be a continuing environment of historically low rates.

Falling yields have rewarded bondholders for over four decades

Sources: Bloomberg, Federal Reserve Economic Data, European Central Bank (ECB). As of April 30, 2020.
Line chart comparing 10-year government bond yields in Japan, Germany and the United States from 1980 to 2020. The chart highlights that yields have steadily fallen during this time period in all countries.

Bonds’ portfolio diversification benefits are well known, but there may be misconceptions about the relationship between stock and bond returns.

Misconception #1: The inverse relationship between stock and bond returns has been around forever.

This is not the case. In fact, the negative correlation between stocks and bonds is a relatively new phenomenon that emerged in the last 20 to 25 years (see chart below). Prior to the mid-1990s, actual inflation consistently ran well above central banks’ mandates; academics attribute that high inflation mostly to the United States abandoning the gold standard (allowing the dollar to float) and a series of energy crises, rather than to economic growth. Years of inflation led investors to expect higher inflation—and perhaps to doubt central banks’ ability to control it—and so they demanded higher yields to compensate for the risk that inflation would erode the value of their bond returns. While fostering economic growth was, then as now, an essential central bank role, it wasn’t the main driver of policy.

Since the mid-1990s, however, inflation (and inflation expectations) have been more consistent with central banks’ monetary policy mandates. Investors gained confidence that economic growth would be the primary driver of central bank actions and, in turn, of interest rates. With growth in the driver’s seat, the inverse correlation between stocks and bonds emerges: Higher growth drives interest rates higher and bond prices lower, but equity prices rise as growth lifts corporate earnings. (And vice versa in the case of lower growth: Bond prices rise, equity prices fall.) Looking ahead, we expect current dynamics to prevail.

Stock and bond returns have not always moved in opposite directions

Source: Bloomberg. As of June 29, 2020. Note: When yields fall, the price of a bond increases in value.
Line chart shows two-year rolling correlation of daily returns for the S&P 500 and the U.S. Treasury 10-year, from 1970 to 2020. The chart highlights that from 1970 to 1998, correlation was above zero, but since then, correlation has dropped below zero (i.e., an inverse relationship).

Misconception #2: The inverse relationship of stocks and bonds is all that matters.

Not really. It’s not enough for bond values to rise as stocks fall. How much bonds appreciate when stock values decline—what we might call the extent of the portfolio insurance bonds provide—matters as well. That depends largely on the sensitivity of a bond’s price to a change in its yield (technically, its duration), and also on how much room yields have to fall.

Here’s the bad news: The amount of portfolio insurance bonds can provide appears to be shrinking as longer-term government bond yields move toward or below zero. The room for bond yields to decline is naturally lower when central banks push their policy rates near or into negative territory. For example, in the Q1 drawdown induced by COVID-19, owning 10-year German bunds or Japanese government bonds (JGBs)—which had yields lower than those of U.S. Treasuries and were arguably closer to their lower bounds—provided less protection than owning U.S. Treasuries (see chart below).

Here’s the good news: The portfolio insurance benefits of U.S. Treasuries are seemingly intact. Even if 10-year Treasury rates fall only as far as zero (we don’t believe negative rates are in the cards), there is still some portfolio insurance left in longer-dated Treasuries. Furthermore, with upward-sloping yield curves, investors can find portfolio insurance and more yield further along the curve in longer maturity, longer-duration bonds.

Low rates have reduced the portfolio insurance provided by intermediate-term government bonds—though less so for U.S. Treasury bonds

Source: Bloomberg. As of June 29, 2020. Percentage offset is defined as the percentage of the equity drawdown in each market offset by the return of the corresponding 10-year government bonds.
Bar chart shows % offset, average for each decade, in local FX for the United States, Germany and Japan across three time periods—2000s, 2010s and COVID-19 through March 31, 2020. The chart shows that the bar for the United States has remained relatively the same during these three time periods, while the bars for Germany and Japan have fallen significantly from the 2000s to present.

The answer is two-fold, and goes back to our definition of core bonds. Remember, in the context of portfolios managed by our Chief Investment Officers (CIOs), core bonds are a broad set of high-quality fixed income securities that serve as the centerpiece of a client’s stable portfolio allocation. Beyond government securities, core bonds include investment grade corporate bonds, agency-backed securities and high-quality municipal bonds.

So, first, core bonds can offer a yield advantage over cash. This advantage is currently greater than 1% for both global aggregate bonds hedged into USD and intermediate municipal bonds (ignoring the tax advantages to certain municipal bond investors).  

Second, core bonds provide some degree of protection that cash is unlikely to provide. An active manager can tactically target different sectors, in addition to intermediate- and longer-duration Treasury bonds, to offer greater protection.

In short, the extra yield of core bonds over cash, the various ways core bond exposure can be sourced, and the potential for these bonds to provide some level of portfolio insurance continue to make core bonds a worthwhile holding within a portfolio’s broader asset allocation.

Amid the low-rate environment, and central bank forward guidance suggesting that cash rates are likely to remain low for a long time, portfolios managed by our CIOs maintain tactical flexibility to capitalize on market opportunities in a manner consistent with a client’s overarching risk preference.

 

Investors that have relied on cash and low-risk sovereign bonds to achieve their financial goals will likely have to adapt in one of two ways:

(1) Reduce their income expectations; or

(2) Be comfortable taking on more risk

Rates are low, and we expect them to remain low for years. Those looking for higher yield will likely need to shift allocations away from cash and sovereign bonds and take on more risk than they have in the past. Below are potential key risk levers (credit, equity, illiquidity and leverage risk) that we think investors should consider in the search for yield, along with our assessment of the current opportunity set. The use of any of these levers can and should be customized to an investor’s individual risk tolerance. Within CIO portfolios today, for example, we are tactically leaning into high yield, given the attractive risk-return dynamics, while maintaining duration via core bonds.

Speak with your J.P. Morgan team about how the considerations and opportunities discussed here may support your long-term goals. 

Risk levers for potential yield enhancement

Source: J.P. Morgan Private Bank, as of July 8, 2020.
Table showing lever, risk and potential opportunity for credit risk, equity risk and illiquidity risk, among others.
1 Core bonds are a set of high-quality fixed income securities that, in the context of portfolios managed by our Chief Investment Officers, can serve as the centerpiece of a client’s stable portfolio allocation. For taxable bond accounts, we define core bonds as a mix of global, developed market government bonds, high-quality investment grade bonds and agency mortgage-backed securities. For tax-efficient accounts, we define core bonds as high-quality intermediate-term municipal bonds.