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Tuesday, December 9, 2014
hedging property of Treasury notes and bonds,
a property very much unappreciated by many investors. In fact, I looked through a number of well-known bond books - the types of books a novice investor would pick up at the library or bookstore if he or she was seeking to learn about bonds. The books waded through duration and how bond prices work and the different types of bonds and the various risks in investing in bonds. But nothing about the all-important hedging property.
This is important because, when one looks at longer term performance, it is a legitimate question on why bonds should even be held in a portfolio.
And, the reasoning isn't complicated. Treasury notes and bonds offer a very decent hedge for that very real possibility that stocks could go to hell in a hand basket! I n fact, as pointed out in the previous posts, bonds had a positive return in all of the down markets of the past 20 years. In 2008, they produced a positive return exceeding 5% as stocks fell 37%!.
Let me put it like this: if someone tells you they gave up on the investment markets because of what they experienced in 2008, then it is a good bet that they had minimal or zero exposure to Treasury notes and bonds.
Why are bonds a really good hedge? This isn't rocket science: when markets get scared, people dump stocks and jump into the safest security in the world - U.S. Treasury notes or even bonds. In doing this, they push up the prices of notes and bonds, thereby producing a positive return when stock prices fall.
This week, Josh Brown of
"The Reformed Broker"
reported correlation statistics calculated by Richard Bernstein. If you look at the correlation chart in the article, you find that Intermediate Treasuries and Long Term Treasuries had the highest negative correlation with the S&P 500 of all the asset classes shown over the period examined.
As regular readers know, I am not a fan so much of correlation statistics because they are basically fancy-dancy averages and, as any average can, they have the potential for throwing the unwary investor for a loop. Everyone has heard the tired joke about the man who crossed the river that had an average depth of 3 feet.
To be clear, let me bring up the obvious deterrent of low rates. It is important to be careful because the risk of a sharp rise in rates continues to hang out there. For this reason, you need to be careful in how much is invested in longer duration Treasuries, or bonds of any type. Nobody is saying this is easy!
In this case, though, the underlying logic is what is important. In the same way that you may fantasize what you would do if you were President, portfolio managers know what they will do when markets panic. They will pile into Treasuries!