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Buffer Equity Market Sell-Offs With Government Bonds: BlackRock

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As a buffer against equity market sell-offs, BlackRock is advocating for a strategic allocation to government bonds — despite their low potential returns — in its global weekly commentary.

“Government bonds have provided a buffer against equity market sell-offs for much of the post-crisis period,” writes Richard Turnill, global chief investment strategist at BlackRock Investment Institute. “Bond prices have tended to go up when stock prices have gone down and vice versa, displaying a negative correlation on average.”

According to Turnill, this pattern played out again early last week when North Korea-related geopolitical concerns escalated.

Turnill says this is a “timely reminder to diversify equity risk via an allocation to government bonds.”

“This is especially true at a time when some investors have lost faith in this principle following several notable episodes in recent years when stock and bond prices moved together,” he added.

For example: the “taper tantrum” of 2013 in response to Federal Reserve hints about tapering and the 2015 spike in German bond yields. According to Turnill, in these episodes, rapidly rising rates undermined confidence in equity markets, which resulted in bond allocations amplifying rather than reducing portfolio losses.

“Fears of similar upsets appear to be holding back investment flows into government bonds, while thirst for income has boosted other fixed income assets such as credit,” Turnill explains. “A fear of rates rising from historically low levels also may be contributing.”

However, in Turnill’s view, market movements early last week highlight how government bonds can still offer portfolio diversification benefits few other assets can. He also notes that rates have reversed this year from their post-U.S. election surge.

“Our analysis shows government bonds have provided positive returns during periods of significant equity declines, upholding their diversifying role,” Turnill writes. “Of the 22 months since 2010 that featured negative U.S. equity returns, bonds notched positive returns in each month in which equities fell 2.5% or more.”

The one exception to that was during the taper tantrum, he notes.

Turnill does expect interest rates to rise — “albeit at a very slow pace as U.S. and eurozone monetary policies gradually normalize,” he says.

Because of this, he says to expect low or negative returns for government bonds globally in the medium term. For diversification purposes, he advocates strategic allocations to government bonds including Treasury inflation-protected securities, known as TIPS — even in the case where bonds underperform cash.

“We do not advocate large cash allocations, as cash dampens but does not diversify equity risk,” he adds.

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