Treasury Replacement

The most surprising thing I learned from reading papers about low bond yields

I gained a lot of great insights from reviewing the excellent content that asset managers...

January 15, 2021

I gained a lot of great insights from reviewing the excellent content that asset managers have created on the challenge of low bond yields.

I must admit that before reading the papers, I already had a good idea as to what asset managers might suggest (better combinations of assets that could provide both risk-mitigation and higher returns). However, there was one angle that I hadn’t given much thought to - the impact of inflation.


Risk-off events have typically been deflationary in nature and therefore nominal Treasuries have been a superior risk-mitigating asset. During the Great Financial Crisis, for example, nominal treasuries significantly outperformed TIPS. 


However, given the low starting yield on Treasuries the trade-off between nominal treasuries and TIPS may have changed. In fact, having some diversification to benefit from protection against inflationary scenarios could be worthwhile.


Two papers that I read specifically covered this angle - one from Bridgewater and one from JPMAM. 


JP Morgan pointed out that low starting yields and lower overall forward looking returns provide less margin for error with respect to an upside inflation surprise. To protect against inflation while maintaining returns, JP Morgan suggests assets with higher return potential and inflation sensitivity may deserve a larger allocation. 


Bridgewater also provides good analysis on the benefit of diversifying out of nominal bonds into inflation-linked assets. They point out that both stocks and bonds do well in deflationary environments and less well in inflationary environments. However, the benefit of holding bonds alongside stocks is due to the different performance in economic downturns. With that benefit diminished due to lower starting yields, the diversifying benefit of protecting against inflation could be more beneficial for future environments.


A key theme from all the papers I read on the impact of lower bond yields, is that investors should begin with the outcome they are hoping to achieve by holding Treasuries and then assess alternatives against that on a forward-looking basis. Most asset managers also suggested taking a diversified approach to risk-mitigating assets to benefit from having a robust portfolio that is more likely to deliver in the scenarios that are needed. 


Against this backdrop and considering potential future scenarios, it could make sense to reassess the allocation between nominal bonds and assets that provide some inflation protection as part of a risk-mitigating portfolio.





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Ed Studd

CEO, Zermelo

Ed is passionate about helping institutional investors meet their goals through better custom solutions. Prior to Zermelo, he gained extensive experience across asset management, investment banking and investment consulting.

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