Long-dated Treasuries' horrible year seen as a one-off

The alignment of stars that made long-dated U.S. Treasuries more of a problem than a solution for institutional portfolios last year is unlikely to be seen again anytime soon, leaving room for those bonds to reclaim their role as a core risk-off allocation for asset owners this year, analysts say.

The events of the past week — when SVB Financial Group announced hefty losses, igniting a run on its Silicon Valley Bank affiliate that quickly drove the bank into the ground — provided a stark reminder of their defensive charms. Even as fears of financial market fragility shaved 3.4% off the S&P 500 index of large U.S. companies between March 8 and March 13, safe-haven buying of long-dated Treasuries sent yields tumbling, providing holders with an offsetting gain of more than 4%.

Still, few can deny that investor faith in long-duration bonds was seriously dented last year after they failed to cushion hefty stock market losses prompted by the start of an aggressive Fed rate hiking cycle.

For the year, the S&P 500 tumbled 18% and the Bloomberg U.S. Aggregate Bond index slumped 13%, leaving a classic 60% equities/40% bonds mix nursing a painful 16% loss.

And it's too soon to say the days of double-barreled losses for stock and bond portfolios are over. In congressional testimony March 7, Federal Reserve Board Chairman Jerome Powell reminded markets he's prepared to ratchet up the pace and scale of rate hikes should the economy remain too hot to bring inflationary pressures off the boil.

With resulting expectations for the terminal rate for Fed hikes potentially set to drift higher, risks remain for both sides of a 60/40 portfolio, said Elizabeth Burton, New York-based managing director and client investment strategist with Goldman Sachs Asset Management's client solutions and capital markets division. GSAM reported $2.3 trillion in client assets as of Dec. 31.

Still, many analysts expect the conditions that set the stage for correlations between stock and bond market returns to go to 1 last year, leaving both asset classes suffering painful losses, to prove ephemeral.

The biggest risk for those correlations going to 1 is when "the Fed gets really fired up to fight inflation," as with the central bank's "uh-oh" moment last year — when inflationary pressures it had deemed transitory proved anything but, forcing the central bank to shift aggressively to catch-up mode, said Jason Vaillancourt, global macro strategist with Boston-based Putnam Investments.

"That's when you really experience the strongest positive stock-bond price correlation," noted Mr. Vaillancourt. But such episodes occur in short bursts and with the Fed frontloading so much of its fight against inflation — with 450 basis points of short-term policy rate hikes over the past year — the conditions required to maintain correlations at 1 this year are unlikely to persist, he said.

The resetting of rates for a more inflationary environment over the past year, meanwhile, should leave long-duration Treasuries poised to play a supportive role again in institutional portfolios.

"The ballast that comes from the duration portion of traditional core fixed income is going to matter again this year in a way that it didn't help really last year," Mr. Vaillancourt said.

Putnam reported $164.9 billion in assets under management as of Dec. 31.

At the close of trading on March 14, the yield on the 10-year benchmark treasury bond stood at 3.69%, down from 3.99% on March 8, the day before the SVB news came out, but still up sharply from 2.14% a year before and 1.63% at the start of 2022.

Differing views on the Fed's likely path from here could determine just how passionately market players move to embrace long-duration bonds this year.

"The question for the 60/40 investor going forward is are we going to be in an environment of … higher than normal inflation ... with some degree of uncertainty around Fed policy," asked Jared Gross, New York-based managing director and head of institutional portfolio strategy with J.P. Morgan Asset Management.

In such a scenario, "negative correlations won't be as negative going forward and the diversification (that) 60/40 provides won't be as effective," he said.

J.P. Morgan Asset Management reported AUM of $2.4 trillion at the close of 2022.

Some portfolio managers contend the Fed can be counted on to play its traditional rate-cutting role in economic downturns.

"There's never been a recession here in the U.S. without a substantial fall in interest rates," and Treasuries will be the biggest beneficiaries in such an environment, noted Molly Schwartz, a portfolio manager with Pasadena, Calif.-based Western Asset Management Co., during a web-based market presentation.

And if there's not a recession? Bonds still do well, "given what they're pricing in in terms of inflation and the Fed worry," Ms. Schwartz said.

WAMCO reported $394.9 billion in AUM as of Dec. 31.

Others are more cautious.

"We are not long duration as we head into recession, and that has to do with the driver of this recession, which is central banks overtightening," said Wei Li, London-based managing director and global chief investment strategist with BlackRock Investment Institute, in an interview.

For recessions caused by excess buildups in the economy, central banks would normally be expected to cut rates, but this time around the Fed is likely to face challenges pushing inflation below 3%, leaving it constrained from cutting rates anytime soon, Ms. Li predicted. And when it finally can trim rates, perhaps a year or more from now, it will only be able to do so very tentatively, she said.

As a result, "the negative correlation between stocks (and) bonds that we got used to … in previous recessionary episodes, we don't think we can count on" as effectively this time around, Ms. Li said.

BlackRock reported combined fixed-income assets under management of $2.5 trillion as of Dec. 31, down 10% for the year year as market-related losses of $444 billion in a rising rate environment more than offset net inflows of $250 billion.

Others contend that negative correlations, while attractive for hedging purposes, shouldn't be seen as a be all and end all in making bonds a core holding for diversifying and hedging portfolio exposures.

"As long as stocks and bonds are not perfectly, positively correlated ... bonds can provide diversification benefits to a stock-bond portfolio," noted Bruce Phelps, managing director and head of institutional advisory and solutions with Newark, N.J.-based PGIM Inc., in an email.

PGIM reported fixed income AUM of $770.2 billion as of Dec. 31.

Mr. Phelps, in an interview, said over the past 60 years there have been long stretches where stock-bond correlations were negative — largely between zero and -0.3 — or positive, by roughly the same quantum.

Even when stocks and bonds were positively correlated, bonds remained a "diversifier par excellence," delivering return without a lot of volatility — properties that are hard to come by, he said.

And at the end of the day, the differences in outcomes and portfolio volatility between those positive and negative periods of correlation weren't significant, PGIM executives said.

Still, chief investment officers have to forecast future stock-bond correlations for portfolio construction purposes. If a 60/40 portfolio was optimal for a CIO anticipating a stock-bond correlation of -0.2, a correlation of 0.2 going forward could point to a mix of roughly 63% in equities and 37% for bonds, said Noah Weisberger, managing director, institutional advisory and solutions, in the same interview.

At recent conferences PGIM organized in London and New York with, on average, 15 senior pension fund and endowment executives, the vast majority said while stock-bond correlations were a matter of considerable importance to them, most assumed a correlation of zero — the biggest surprise of PGIM's research because "it sounds so nihilistic … how little it matters," Mr. Weisberger said.

PGIM's calculations support that view, showing a dollar invested using faulty correlation assumptions over the 52-year stretch since 1970 growing to $87, not far below the $92 achieved on the basis of accurate assumptions.

Messrs. Phelps and Weisberger said turning away from bonds now on account of their drubbing last year would be an ill-considered move. Bonds have repriced to reflect an inflationary world, and in a risk-off environment, they "will be there to provide a cushion against stocks" — possibly not as good a cushion as before, depending on the correlations, "but still a cushion," Mr. Phelps said.

BlackRock's Ms. Li, citing the Fed's constraints in cutting rates, took a dimmer view on the impact of less negative stock-bond correlations. "We like duration for income but we question the efficacy of duration as a recession hedge," she said.

Likewise, J.P. Morgan's Mr. Gross conceded that "correlations below 1 allow for a mathematical level of diversification, but in the real world a much lower level of correlation is needed to justify top-down portfolio risk management embodied in the '60/40' model," he said.

It's hard to pin down the exact level at which stock-bond diversification becomes problematic, Mr. Gross noted. Still, even if the diversification bonds offer is somewhat watered down going forward, higher yields and lower risk remain critically important reasons to hold bonds in a portfolio, he said.

Both Mr. Gross and Ms. Li noted the attractions now of shorter-dated U.S. government paper, in a market with 1-year Treasury bills yielding still well over 4%, down from 5% following the SVB news, maintaining an advantage of more than 80 basis points over 10-year Treasury bonds.

"We are seeing large institutions ramp up shorter-dated and core fixed income" in response to the current yield environment, Mr. Gross said.

Meanwhile, Mr. Gross said the advice he was offering investors over a year ago — to "rely less on duration, improve the liquidity of your position by shortening your bond portfolio, and moving toward cash and moving some of your equity risk into alternative asset classes" — still holds water today even as market conditions have evolved.

But rather than a 60/40 template, Mr. Gross said allocations of 40% to traditional equities, 30% to diversified alternatives, including secondaries, and 30% to "full spectrum fixed income" — including short, core (securitized, investment-grade and Treasuries), high yield and loans — could offer better prospects.

BlackRock's Ms. Li said the BlackRock Investment Institute's underweight to the long end of the Treasury curve now is offset by allocations to the short end of the curve, resulting in a neutral weighting overall to government bonds.

She reiterated that getting the portfolio mix right should prove especially important this year, necessitating a more nimble approach to tactical and strategic asset allocation shifts alike.

Putnam's Mr. Vaillancourt said his firm continues to see more search activity for private credit than for the duration provided by long-dated government bonds. But he said there's reason to expect bonds to garner more and more attention this year. With the sharp surge in interest rates over the past year reducing the liabilities of U.S. corporate pension plans, producing a "once-in-a-generation level of funding status," the natural response for plan executives should be to derisk. "The best way to that you could do that at this point is moving back toward your core fixed-income allocation," adding duration back, he said.