One of the hardest parts of investing is the challenge of continuously adjusting to ever-changing market conditions, as well as the need to unlearn certain methods that have worked for a long period of time.
In the past, central banks have found new and innovative ways to support the economy and markets, helped by the low-inflation backdrop. This has resulted in a lower-for-longer interest-rate environment and outright support for both government and corporate-credit markets.
The question now is whether the coronavirus-induced new normal will alter the oldest trick in investor playbooks: that of hedging risk with government bonds. While this worked relatively well in the first quarter of this year, rates have since stayed in a narrow range as equities and credit have rallied (see figure 1).
Figure 1. An emerging divergence: government bonds, credit and equities
Source: Bloomberg, ICE Bond Indices, as at September 2020.
Even the uptick in volatility, increase in bid-offer spreads and breakdown in the correlation between government bonds and equities in March did little to inspire confidence in Treasuries as a safe haven during material drawdowns.
Rates have also failed to materially respond to the latest equity-market sell-off (the high-yield market has held up relatively well, due to differences in its sectoral composition and its attractiveness in the reach-for-spread environment).
Only time will show whether rates will provide protection in this new environment. But at the very least, fixed-income investors must look for new ways to defend against the downside – whether this is in the form of taking a more flexible, high-conviction approach to credit, or drawing on new instruments like options to hedge against risks.
