One man’s trash is another man’s Treasury

The appeal of bonds for many investors is simple and enduring. They cushion portfolios against stock market tumbles, and pay a positive return to boot. At least, that’s the theory.

When US equities shed a quarter of their value following the collapse of Lehman Brothers in September 2008, yields on 10-year US Treasuries dropped from 4% to a little over 2%. Man Group’s Peter van Dooijeweert reckons investors made about 20% returns on 10-year US Treasuries over the financial crisis period.

Things are different now. Interest rates are bumping along at rock bottom, and bond yields are at historic lows. To gain the same level of protection in a similar crisis today, 10-year yields would have to fall well below -1%, van Dooijeweert said during a press briefing earlier this year.

That seems a bold assumption. But Man’s pension fund clients struggle to see an alternative diversifier that can be scalable to the same degree that bonds are. “We spend a lot of time speaking to clients about the role of bonds going forward,” van Dooijeweert said. It’s anything but clear.

The case for holding on to government bonds rests on the belief they would still cushion portfolios in a crisis.

A pension fund CRO explains it like this. An investor valuing a US Treasury like a corporate bond would consider it worth next to nothing – the debt burden is high, the economic outlook poor, revenues are stretched, and the management is chaotic. But in practice, the value is close to a hundred.

The reason, of course, is that Treasuries are liquid and fungible. They can be exchanged for cash via repo, or posted as collateral. They are a natural harbour in a storm. So their value will generally rise as skittish investors flee the vicissitudes of the stock market.

When bond yields turn negative none of that necessarily changes. Research from US investment firm First Quadrant suggests bonds continue to provide downside protection even when yields are as low as they’ve been in Germany and Japan in recent years.

Federal Reserve and ECB research also indicates that banks dump stocks and buy liquid assets in a crisis, says First Quadrant’s Ed Peters. “They need liquidity. The yield isn’t relevant in that environment.”

On the other hand, with scarce data on exactly how bonds behave when yields are negative, nobody can be overly confident about their qualities as a future hedge.

Peters acknowledges the uncertainty. If investors are holding bonds for downside protection and diversification “then, at the moment, that’s okay”, he says – but he adds: “We don’t know for sure.”

Of course, weighing the diversification properties of bonds isn’t the only problem institutional investors face. Low yields themselves are a huge concern. “If your return requirements as a pension fund are 7% or 8% and bonds are yielding 60 basis points, you have a real problem,” van Dooijeweert said.

The paltry yield leaves investors with a ticklish decision to make. If the rationale for buying bonds is they provide downside protection with a regular coupon, take away the coupon and what are you left with?

The answer looks a lot like an option. Investors may reason they’re better off buying a put option against a stock and paying a premium rather than bleeding a negative real yield on their bond holdings. Each may amount to much the same financially, but the option provides a more perfect hedge against equity losses.

Bonds or options: it’s a call investors increasingly will have to make.