The hallmarks of bond investing have long been stability and yield. Having an asset with a negative correlation to the equity markets is something that holds value in portfolio construction. A strong yield helps smooth out the bumps along the investing road, and that comforts investors. Do these conditions exist in today’s market environment?
Everyone acknowledges we are in a unique place in bond markets, but few people realize just how extreme it is. March 9th 2020, for the first time in history, investors woke to US Treasury markets (including the 30 year bond) all below 1%. Liquidity was the worst it had been since the height of 2008, and maybe ever. The Treasury market was not the safe haven it had previously been. What is important to understand is, ‘why?’. Why were these instruments less liquid and why were they no longer trading steadily for investors? The answer is more complexity, and less desirability.
Investors are starved for yield and buying it up at alarming rates. This hunger for yield is pushing rates lower and lower. As a result, investors struggle to attain their respective hurdle rates and they end up extending duration and lowering credit quality. Additionally, managers get creative in ways to obtain a few extra basis points on the lower yielding assets in their book. Treasury portfolios of on-the-run securities are the most liquid and have the lowest yield. Often investment managers will pick up off-the-run Treasuries as they have less liquidity and, as such, trade with a higher yield. That practice can help portfolios in normal times but became expensive in March, when the stress in markets made these portfolios illiquid to even the largest institutional players and the largest bond shops in the business. The lack of liquidity is not the only negative for bonds currently. We question if they will be able to produce the same type of negatively correlated returns that we saw in 2008, and March of this year.
March of 2008, 30-year rates were over 4.75%, a far cry from the approximately 1.75% they were trading at in March of 2020. Does this lower starting point in rates have any effect on how the bonds behave? We would argue that it does. In 2008, the 30-year rate moved down (from high to low) 2.27 points. That move saw the SPDR Portfolio Long Term Treasury ETF (SPTL) rally 26.31%. Fast forward over a decade to March of 2020 and the 30-year rate fall 0.792 points. That drop moved the corresponding ETF index (SPTL) 17.6%. While this move was very nice for investors, it failed to provide the same magnitude of return as the 2008 drop. With rates sitting lower today than the beginning of March, we feel another round of trouble will likely follow this trend of lower highs in Treasury markets.
What does provide an uncorrelated return to equities? A Put on the equity market. We maintain that currently this setup makes owning yielding equities with downside protection a more attractive risk/reward proposition than the traditional 60/40 model and will for years to come.
Partner, Portfolio Manager
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