In the previous article, we talked about the idea of the “miracle of lowest correlations” by including U.S. treasury bonds in the portfolio of defensive sectors. In this article, we address the fundamental reasons why U.S. treasury bonds work so well in conjunction with indexes and why corporate bonds are not a true alternative to them.
brief information about the dynamics of interest rates
When the economy is doing well and, as a result, securities indexes are also growing, the central bank raises the interest rate on issued loans to make more money. This causes a chain reaction of rising interest rates for all current issues of debt instruments, such as bonds or bank deposits. This means that earlier issues of debt instruments at a lower interest rate than now become less attractive and their prices fall.
When the economy is doing badly and as a result paper indexes fall, the central bank lowers the interest rate to prevent a wave of bankruptcies associated with the excessive debt burden of companies in crisis when they are unable to pay their debts at previous interest rates. This means that previous issues of debt instruments at a higher interest rate than now become more attractive and their prices rise.
Let’s take a look at the chart of the Fed interest rate dynamics compared to the dynamics of the S&P500:
Federal Reserve interest rate (orange) vs. S&P500 dynamics (green)
As you can see in Chart 1, when there is a recession and a reaction to it in the form of a rapid decline in the S&P500 index, the Fed begins to respond by cutting interest rates to restructure credit and reduce credit pressure on businesses. And it really works, as the market recovers quite quickly after the interest rate is lowered to the required level.
Now let’s look at how the U.S. Treasury bond rate responds to the Federal Reserve rate cut and hike:
Federal Reserve interest rate (orange) vs. 10-year U.S. Treasury bond rate (green)
Interest rates on debt instruments are highly correlated with movements in the Federal Reserve’s rate (Chart 2). I’m sure you have observed more than once that during crises, interest rates on bank deposits fall. The same thing happens with all other fixed-rate instruments.
Let’s now look at how the package price of past issues of US Treasury bonds reacts to an increase or decrease in their interest rate:
ETF TLT price (green) vs. 10-year US Treasury bond interest rate (orange)
We can see a very strong negative correlation (Chart 3): interest rates have fallen and the value of outstanding bonds has risen. This can be explained with a very simple example:
We bought a 10 year bond with an interest rate of 5%. A year later the interest rate was raised and now bonds are issued at 10%. Of course, we want 10% per year, not 5%, so we have to sell the current bond to buy the bond that is currently being issued at 10%. But no one wants to buy our bond at 5% yield per year from us when you can buy a bond at 10% yield but not from us. So we have to give a deep discount on our bond. A discount so high that it would be pointless for us to sell our bond and we would lose as much as we would gain by replacing the bond. In other words: if the interest rate goes up, our bond, which was issued at the previous low interest rate, becomes cheaper.
If the bond rate goes back down to 5% next year, we won’t have to give a discount on our bond at 5% because the current bond issues that can be bought NOT from us are in no way superior to our bond in terms of yield. But last year’s bond, issued at 10%, is bound to skyrocket in price. And since there are no such high-yield bonds left, no one will sell them cheap – only at much more expensive than last year’s prices. In other words: when the interest rate goes down, our bond that was issued at the previous high interest rate becomes more expensive.
This simplified example explains the negative correlation between the price of issued bonds and the current interest rate on their new issues.
Corporate bonds as an alternative to government bonds
In addition to US government bonds, there are also corporate bonds. They too are a fixed income instrument. In theory, they should respond to interest rate increases or decreases in a similar way, but in practice this is far from the case. We will now examine why corporate bonds are not suitable for our investment portfolio and how they differ from US government bonds on a statistical and fundamental level.
Why corporate bonds are not suitable for us:
Simply put, corporations, unlike the government, do not have permanent tax revenues. Moreover, in the event of a default, the government can simply print a large amount of money and pay off its debt through inflation. Corporations, on the other hand, do not have this option. Therefore, during recessions, non-government bonds are at high risk of defaulting and the money for the bonds will not be repaid. All of this causes corporate bonds to fall during crises and does not give us the necessary negative correlation with the market.
Let’s look at “junk” bonds, unreliable bonds, as an example of increased correlation with the S&P500:
ETFs on unreliable corporate bonds HYG (red) and SPY (blue)
Due to the increased default risk that rises during recessions, unreliable bonds cannot provide us with a negative correlation with the S&P500 (Chart 4, red box) in its falls (Chart 4, black boxes). This type of bonds makes absolutely no sense for our portfolio, as it behaves almost identically to ordinary securities.
But what if we take high quality corporate bonds?
High quality corporate bonds LQD (red) and SPY (blue)
Although the high quality LQD bond ETF falls less and correlates less with the market, it still has a positive correlation with the S&P500 (Chart 5, red box). No matter how reliable corporate bonds are, their default risk still increases during a recession. They are also unable to provide us with a qualitative negative correlation with the market during deep drawdowns, which stabilizes our portfolio.
Now let’s look at how U.S. government bonds respond to the lowering of interest rates during market declines:
20 year+ US government bonds ETF TLT (red) and SPY (blue)
A completely different story! A high quality instrument with vanishingly low default risk in a crisis that reacts with full force to the lowering of interest rates. This gives us a negative correlation with the market when it falls (Chart 6, red box). This is exactly what we need to create a balanced and secure portfolio.
Let’s compare portfolios with different bond types and the S&P500 at a 50% to 50% ratio to better understand the impact of each bond type on the portfolio:
HYG+SPY (blue), LQD+SPY (red), TLT+SPY (orange).
As you can see, only the quality of U.S. Treasury bonds gives us exactly what our portfolio needs – the lowest possible correlation with the market (Chart 7, red box). The portfolio has the lowest standard deviation (Chart 7, purple box), the lowest maximum drawdown (Chart 7, blue box) and the highest return (Chart 7, green box)!
Let’s now compare the performance of the portfolios based on the eSharpe and CALMAR ratios, which we already know from the previous articles:
HYG+ SPY – 6.87 / 12.71 = 0.54 eSharpe and 6.87 / 37.64 = 0.18 CALMAR
LQD+ SPY – 7.56 / 9.92 = 0.76 eSharpe and 7.56 / 27.55 = 0.27 CALMAR
TLT+ SPY – 9.34 / 8.68 = 1.07 eSharpe and 9.34 / 17.45 = 0.53 CALMAR
The TLT + SPY [50%+50%] portfolio far outperforms lower quality portfolios in terms of risk and return. It implements the “Miracle of Lowest Correlations” by using the lowest possible correlation of U.S. government bonds to the market.
Now you know precisely which bonds to include in your portfolio to maximize its efficiency and minimize its risks.
Do you have any remarks or questions regarding this article? Leave a comment below this article or contact me here. I always answer all questions without exception.
Have a great day and I’ll see you in the following articles!