Investors seem to be in a constant state of searching for investment alternatives. We are all in a certain sense looking for the perfect portfolio diversifier. The sad case of the MainStay Marketfield fund is just one example of this behavior. This year has been especially painful for equity investors as global equities have pretty much been in a lockstep, free fall all month long.
If only there were an asset class that possessed little (or no) credit risk and had a tendency to outperform when equities tanked? If only…Wait there is an asset class just like that. It’s called US Treasuries. A year ago Wes Gray at Alpha Architect had a popular post up showing the performance of long term US Treasury bonds during substantial drawdowns in the S&P 500. He wrote:
Long bonds are clearly interesting in a portfolio context. In addition to providing a real return, plus an expected inflation return, the asset serves as a quasi-insurance policy: When stock markets blow up, US long bonds do well, on average.
The resilience of this finding is remarkable. In the context of a traditional asset pricing model, such as the Capital Asset Pricing Model (CAPM), an asset that actually delivers returns when the rest of the world is blowing up (I.e., negative beta during treacherous times), should have a negative expected return because of the diversification benefits. But with US Treasury Bonds, we actually earn a positive expected return AND get the insurance benefit. One might even consider the US Treasury bond “anomalous.”
In 2016 it has certainly been the case that US Treasuries have served as a hedge against a rocky stock market. Below you can see the positive performance of bonds vs. stocks YTD.
It is ironic that going into 2016 much investor angst was focused on bonds and the threat of further Fed rate hikes. Ben Carlson at A Wealth of Common Sense talks about lessons learned during this market sell-off and the proper place of high-quality bonds in a portfolio. Carlson writes:
The threat of rising rates and interest rate risk has many investors extremely worried about losses in their bonds. While I think it’s reasonable to lower your expectations for bond market returns and allow for higher volatility because of the level of rates, it seems to me that many of the fears about fixed income are overblown. Investors just have to make sure they define their reasons for investing in bonds in the first place. High quality bonds can still be used for principal protection and a hedge against stock market risk.
Admittedly Treasury bonds and high grade corporate (and muni) bonds are not all that exciting. Nor should they be. History has shown us that during extended stock market declines these asset classes can serve as much needed portfolio ballast. They may not in any sense of the word be ‘alternative’ but they do serve as an alternative for equity-centric investors.