T. ROWE PRICE INSIGHTS ON U.S. FIXED INCOME
Treasuries Still an Effective Hedge for Credit Risk 30-year bonds have room to appreciate in a major risk downturn. October 2020
KEY INSIGHTS ■■ We believe that U.S. Treasuries are still an effective diversifier and hedge against major selling pressure on risk assets such as corporate bonds. Christopher Brown, CFA ■■ We favor maintaining exposure to 30-year Treasuries as a form of downside risk Lead portfolio manager for Total management against a steep sell-off that causes credit spreads to widen quickly. Return Fund ■■ Our quantitative research team has examined the relationship between the level of credit spreads and the appropriate size of a Treasury hedge.
Derek Chen, CFA, FRM here has recently been a fervent “Safe-Haven” Status for Treasuries Fixed income quantitative analyst debate among investors and in the U.S. government debt typically benefits financial media about the efficacy from its “safe-haven” status in times T 1 of U.S. Treasuries as a risk hedge in the of risk aversion, so Treasuries have current environment of historically low historically provided a solid hedge against yields. We believe that U.S. Treasuries selling pressure on risk assets. When are still an effective diversifier and hedge Standard & Poor’s cut its credit rating on against major selling pressure on risk the U.S. government to AA+ from AAA in assets such as corporate bonds and 2011, stocks sold off and credit spreads equities, although the utility of Treasuries widened, while Treasuries rallied—the as a hedge may be more limited in a opposite of what many would have 2 modest downturn in risk markets. We expected from downgraded debt. favor maintaining exposure to 30-year Treasuries as a form of downside risk In addition, Treasuries have benefitted management against a steep sell-off from the U.S. dollar’s status as the world’s that causes credit spreads3 to widen reserve currency, supporting demand quickly along the lines of the downturn over the long term. Treasury bonds also triggered by the onset of the coronavirus provide regular income. This gives them pandemic in March. an advantage over a hedging instrument such as gold that does not pay interest.
1 A hedge is an investment that is made with the intention of reducing a certain risk or risks associated with an asset. 2 Diversification cannot assure a profit or protect against loss in a declining market. 3 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar-maturity, high-quality government security.
1 Historical Negative Correlations (Fig. 1) Correlations between Treasuries and U.S. stocks
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Dot-Com Global Eurozone COVID-19 Stock Bust Financial Crisis Debt Crisis Pandemic
Past results are not indicative of future results. As of September 18, 2020. Sources: Bloomberg Finance L.P. and T. Rowe Price. Treasury returns represented by the S&P 30-Year U.S. Treasury Bond Futures Total Return Index (weekly data), U.S. stocks represented by S&P 500 Index (weekly data). See Additional Disclosures. Correlations are over the trailing 6-month period; correlation calculations by T. Rowe Price.
High-quality government bonds from correlation4 between Treasuries and other countries have been useful in the risk assets in major risk-off environments …correlation is not past as a credit risk hedge. However, the to continue. long-standing, aggressive quantitative the only metric easing programs of the European While clearly important, correlation is Central Bank and the Bank of Japan not the only metric that needs to be that needs to be have limited the amount of German and considered when evaluating the efficacy considered when Japanese government debt available to of hedges. Price volatility is an additional investors and driven yields below zero. major consideration. A hedge should be evaluating the While the low yields on shorter-maturity very reactive to market stress—it should Treasuries have limited income and have ample volatility. When it comes to efficacy of hedges. room for further appreciation, we believe government bonds, the product of two 5 longer-term Treasuries still have an factors—duration and yield volatility— advantage over high-quality non-U.S. can adequately capture price volatility. government debt in terms of income and Both factors have been positively appreciation potential. correlated to overall price volatility (the higher, the more volatile). By definition, Correlation and Price Volatility 30-year Treasuries have a high duration. Are Important Considerations And while it’s true that the Federal Relatively low yields may limit the Reserve’s various policy responses to effectiveness of Treasuries as a hedge the Covid-19 crisis have dampened yield in a modest downturn in risk sentiment, volatility for most maturities, the 30-year but we expect the historical negative Treasury’s yield volatility has remained more elevated than usual.
4 Correlation measures how one asset class, style, or individual group may be related to another. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all. 5 Duration measures a bond’s sensitivity to changes in interest rates.
2 30-Year Treasury Still an Some observers are concerned that Effective Hedge correlations between Treasuries and For this reason, in addition to leveraging risk assets may turn positive in today’s the insights gleaned from the work of low-yield environment. However, history our fixed income quant team, we have suggests that Fed policy tightening, not adapted our strategies for hedging with low yields alone, is often the trigger for Treasuries to focus on 30-year bonds, short periods of positive correlation. As which should have room to appreciate shown in the chart, Fed tightening in meaningfully if credit spreads rapidly 2006–2007 and 2017–2018, as well widen. As an example, with the 30-year as the “taper tantrum” in 2014 (when yielding about 1.45% in mid-September, the central bank prepared the market a rally creating a 100 basis point (bp)6 for slowing asset purchases), preceded yield decrease—which is possible should times of positive correlations between we experience another severe sell-off in Treasuries and risk assets. We expect risk assets—could generate a meaningful the Fed to maintain its extremely offset to losses on credit exposure. accommodative monetary policy for an extended period, giving us confidence Quantitative Analysis Considers that correlations will stay negative. Income, Price Appreciation Potential, and Correlation Credit Spreads Factor Into Hedge Duration This analysis incorporates the income component of the Treasury hedge Our quantitative research team has also as well as the potential for price examined the relationship between appreciation over time as a result of a the level of credit spreads and the positively sloped yield curve, known appropriate size of a Treasury hedge, as “roll down” return (for example, after which allows us to dynamically manage a year, a 30-year bond would become the portfolio’s overall risk profile in a 29-year security at a lower yield different parts of the credit cycle. In and higher price). Most importantly, it an environment of persistent narrower considers the empirical correlation spreads, which is typical during an between the Treasury position and the economic expansion, corporate credit portfolio’s credit exposure. tends to experience less credit risk as well as lower spread volatility. Therefore, An ideal portfolio construction would the optimal risk hedge position should combine assets that have a modestly be sized to have a lower duration negative correlation as opposed to contribution than when credit spreads exactly -1, which would indicate that are wide. Given the typically strong the changes in value of the Treasury liquidity of Treasury bonds, we should security and the credit position should be able to nimbly adjust the sizes of perfectly offset each other by moving the Treasury hedges in our taxable the same amount in opposite directions. bond portfolios in response to rapidly A correlation between 0 and -1 would changing credit spreads. potentially help dampen downside volatility in the portfolio as credit spreads Duration Risk if Rates Increase widen while maintaining upside potential The flip side of the beneficial hedging in a credit rally.7 Correlations between properties of 30-year Treasuries in a Treasuries and risk assets have recently credit sell-off is their likely losses if risk been in this modestly negative range. appetite strengthens. A meaningful increase in the 30-year Treasury yield
6 A basis point is 0.01 percentage points. 7 Combining assets with certain correlation figures does not assure a profit or protect against loss.
3 would generate a sizable loss, weighing pressures, we collaborate closely with heavily on the gains from the credit our quantitative analysis team when exposure in the portfolio. While we determining the appropriate size don’t think this scenario is likely in the of Treasury hedges in relation to the near term, given subdued inflation portfolio’s credit risk level.
WHAT WE’RE WATCHING NEXT We are closely monitoring the effects of the Fed’s new average inflation targeting framework for monetary policy, which is likely to allow the central bank to keep its benchmark federal funds lending rate at its current near-zero level for several years. We expect this to keep short- and intermediate-term Treasury yields anchored at low levels for the foreseeable future, with the 30-year yield fluctuating to some degree in response to growth and inflation outlooks.
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Important Information Call 1-800-225-5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information you should read and consider carefully before investing. This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are those of the authors as of October 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default, which may affect the value of an investment. Fixed income securities are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only. T. Rowe Price Investment Services, Inc. © 2020 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc.
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