US Treasuries’ Negative Correlation Remains Intact

Western Asset: Treasuries will likely continue to provide an opportunity for investors to diversify their portfolios.

    John L. Bellows, PhD

    There has been a lot of discussion about whether US Treasury bonds will continue to function as a diversifier or hedge for portfolio risk. Some argue that the low level of yields—and by extension the limited amount of room that yields can fall from here—undermines the diversifying properties of Treasuries. While we can all agree that today’s yields are low, it may be beside the point in this particular conversation. The most important characteristic of a hedge is that it should be negatively correlated with risk assets. There are many reasons to expect that US Treasury bond prices and risk asset prices will continue to be negatively correlated, even in this low-rate environment. Accordingly, Treasuries are likely to continue to function as a diversifier for other risks in investors’ portfolios.

    The reasons to expect the negative correlation to persist include the following:

    1. During periods of risk-off sentiment, there is often a “flight to quality” as investors put a premium on safe and liquid assets at the expense of riskier assets. US Treasuries are the most likely beneficiaries of any “flight to quality.” Importantly, during these periods investors care more about the safety and liquidity of what they are buying than they do about the yield, so it’s not clear how the low level of yields would change this type of behavior.


    2. Risk-off sentiment often corresponds with downgrades to expectations for future growth and inflation. This in turn causes risk-free yields to move lower, as future expectations for growth and inflation are immediately related to the level of longer-term risk-free rates. And, of course, a move lower in yields drives prices higher for US Treasury bonds.

    3. With US overnight rates at the zero lower bound, and Fed officials adamant that negative rates are not under consideration, it seems straightforward that yields on short-dated US Treasury bonds are unlikely to fall further. (Of course, in a very extreme scenario the Fed could reconsider its current stance on negative rates, but that seems unlikely over the next few quarters.) Longer-dated bonds are a different matter, however, and it is there that the Fed could do more, if needed. In particular, should the recovery falter or should risk sentiment deteriorate, the Fed could seek to boost financial conditions by extending the maturity of its bond purchases or by providing guidance on the length of time its purchases will continue. Such a move from the Fed would likely contribute to a further rise in prices of longer-date US Treasury bonds, regardless of the level of yields at the time.

    Using negatively correlated assets to reduce portfolio volatility is a very basic idea in finance. Historically, Treasuries have been widely acknowledged to fill that role, and indeed the correlation between US Treasury bond prices and risk asset prices has been reliably negative for the past two and a half decades. Today the low-yield environment has led many to question whether Treasuries will continue to work as a hedge going forward. In questioning the role of Treasuries in portfolios, many investors have posed the question incorrectly. Rather than focus on the level of yields, the focus should be on the property that makes Treasuries a hedge—namely, will they continue to be negatively correlated with risk assets? As long as that negative correlation holds, and as discussed earlier there are good reasons to expect it will, US Treasury bonds should continue to work as a diversifier. As a result, Treasuries will likely continue to provide an opportunity for investors to diversify their portfolios.



    DEFINITIONS

    U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

    Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.

    Hedging refers to making an investment to reduce the risk of adverse price movements in another asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations. Looked at another way, the Treasury yield is the effective interest rate that the U.S. government pays to borrow money for different lengths of time. Risk-on risk-off refers to changes in investment activity in response to global economic patterns where trading activity is highly correlated. During “risk-on” periods when risk is perceived low, investors tend to prefer higher-risk investments. During “risk-off” periods when risk is perceived as high, investors tend to prefer lower-risk investments.

    Flight to quality refers to the action of investors moving their capital away from riskier investments to the safest possible investment vehicles; it is usually caused by uncertainty in the financial or international markets.

    The U.S. Federal Reserve, or “Fed,” is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

    Overnight rate is the interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis.

    Zero lower bound is the lower limit that rates can be cut to, but no further. When this level is reached, and the economy is still underperforming, then the central bank can no longer provide stimulus via interest rates.

     

    WHAT ARE THE RISKS?

    Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.