A recent change in the Innova portfolios was a rotation in our exposure to government bonds, taking a more deliberate exposure to US Treasury Bonds in favour of a broader exposure to global sovereign bonds.
We summarise this investment decision with the following idea:
Evidence suggests that there is still a high chance of recession in the US, and globally. When we look at where assets are priced at the moment, we believe this high level of recession risk is not priced in (for equities in particular) – but at the same time, no model is perfect, and this may not happen.
We therefore want to own assets which can (and historically have) acted as a hedge against equity market downturns and recessionary risks, but also are priced attractively enough today that we’d be happy to hold them if a recession doesn’t end up happening.
[Innova’s internal US recession indicator is pricing in a greater than 70% chance of a recession within 12 months – historically, that has been the point at which recession nearly always happens.]
The Current Case for US Treasury Bonds
US Treasury Bonds, like all government bonds, have an element of total return from their interest payments (yield), as well as the potential for capital gain/loss as a result of the bond price moving inthe open market.
As we covered in our note on a total return model for fixed income, the best place to invest client funds when buying bonds are assets which have an attractive yield and that yield may fall in the future – if you own the asset when the yield falls, you gain in capital appreciation, since yields down = price up.
With that dynamic in mind, consider the below chart of three major yield curves:
The US yield curve is inverted, meaning shorter-dated bonds are yielding higher than longer-dated. This is not a regular phenomenon, as longer-dated bonds require a premium to justify investors locking their funds up for longer periods of time.
Hence over time the yield curve always uninverts, and it may be favourable to invest into the part of the curve that tends to fall (shorter-dated bonds) as you are getting a higher yield and potential capital upside.
In this case, the US yield curve is offering a significantly higher premium over other countries, including the European Union which are also inverted, whilst the Aussie yield curve is actually positively sloping, one of the few major developed economies to still enjoy this ‘healthy’ shape.
Purely looking by today’s merits, buying US Treasuries between 2 – 5 years in maturity yields you around 4.0% per annum on a AAA-rated government security, with potential to provide further upside if the curve uninverts via short dated yields falling below long-dated.
The investment case gets stronger, when you couple the historical attributes of buying bonds with this attractive current setup.
The Historical Case for US Treasury Bonds
Looking back across periods of recession in the US, specifically since the 1960s, US Treasuries have provided support during equity market weakness. We caveat this by saying this was most certainly not the case during 2022, however 2022 was not a recessionary bear market nor were there “normal” dynamics playing out in bond markets.
And more specifically, the 2-5 year region of the US yield curve appears to offer the most consistent profile of return and volatility across time – this consistency, reliable fall in yields (rise in price) and lowered volatility compared to longer-dated bonds, all add to a compelling investment thesis.
Could an investor look at longer-dated bonds to try and seek higher returns? Absolutely.
However despite their higher upside, long-dated bonds have a far greater potential for violent price swings which aren’t suitable to a managed account – they require an active trading hand and a high risk tolerance, and therefore if these became more attractive we’d likely look to an active manager to handle such an investment.
We’ve written before about looking for opportunities to add specific, targeted risk back into the Innova portfolios, as certain areas of the market start to look more attractive.
Though government bonds might not seem like a risky asset, interest rate risk is still something to be managed in the portfolio, and can be a source of capital gain if you are prudent and buy at the right valuations (as with all investments).
We haven’t necessarily added more duration risk to the table, rather switched out of a less focused global basket to a highly targeted investment in shorter-dated US Treasuries – however this is undoubtedly an attractive area to hedge client funds against equity market weakness, collect yield and potentially participate in upside when the US yield curve returns to a positive slope.
To be offered all those three things at once is a rare opportunity, and it’s exactly the type of setup we are constantly looking for.