Treasury Replacement

Zermelo’s Top 3 Papers on Treasury replacement strategies

The current low level of yields on bond portfolios creates many challenges for investors. Bonds have...

January 1, 2021

The current low level of yields on bond portfolios creates many challenges for investors. Bonds have traditionally fulfilled the role of offering reasonable total return and yield, whilst also diversifying and mitigating equity risk. 


However, at near-zero yields the opportunity cost of holding bonds is greater due to the suppressed returns. Investors also question how much scope there is for further yield declines and therefore whether they will be able to offer sufficient protection qualities versus equities going forward.


There is a lot of great content from asset managers on this topic. Here are three of our favorite papers.


1. The Bond Problem, Man Group

Man Group estimates that the return outlook for the traditional 60/40 is unlikely to meet the average return objective for pension plans of 7%. Further, the protective role of bonds is limited by a potential floor on how low negative yields might go.

The paper provides great analysis to support their recommendations, which are to replace Treasuries with higher yielding credit and a robust package of risk-mitigating strategies. The goal for the portfolio would be to generate either no return or small losses in rallies and outsize gains in a decline.


2. A Theoretical Framework for Equity-Defensive Strategies, PIMCO

In this paper, PIMCO examines the general diversification and hedging properties of various well-accepted defensive assets. Namely, Long Treasuries, Tail-risk hedging strategies, Trend following and Alternative Risk Premia

The key trade-off between the strategies is the cost of each approach versus the certainty that it will work in times of crisis.

Pimco creates a theoretical framework to derive an optimal portfolio of risk-mitigating strategies. The paper identifies significant improvements to creating a diversified portfolio across the different hedging approaches rather than relying on any single strategy


3. Grappling with the New Reality of Zero Bond Yields Virtually Everywhere, Bridgewater

This three-part paper series is a must read on the topic, containing great research from Bridgewater.

The papers address the challenges and potential solutions to some of key questions such as how to get diversification, the increased importance of geographic diversification and managing the risk of deflation.

Three key solutions are explored: replacing nominal bonds with inflation linked-assets such as gold and inflation-linked bonds, diversifying across geographies including China and investing in equities with earnings that are expected to approach the consistency of the coupon on a bond.


Finally, whilst not in our top 3 papers, we’d give a special mention to Wellington’s paper : A new framework for downside mitigation

The paper has a great framework for constructing risk mitigation portfolios, which starts with identifying the theoretical drivers of risk mitigation. The next step is to create a portfolio with balanced risk contributions across each of the drivers. This seeks to increase the probability of having exposure to a driver that reacts when needed. A key diagram from this paper is below:


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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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