INTRODUCTION
Welcome to our Asset Allocation Series, where we provide clear insights into multi-asset investment, asset allocation analysis and quantitative research.
After having highlighted the benefits of adding Japan equities and Gold as an asset class in a balanced portfolio in the previous editions, this paper focuses on US long-dated government bonds.
In our view, considering US government bonds and US inflation-linked bonds (TIPS) tend to:
• Increase the expected return over the medium to long term,
• Increase the diversification, and ultimately reduce the investment risks and expected drawdowns,
• Improve the overall risk-return profile of a diversified multi-assets portfolio as a result.
This paper explains why and helps to understand the risk-return characteristics and their impact on investment success, based on a clear vision of long-term historical trends and expected behaviors.
Our Chief Investment Office has recently upgraded US Government Bonds from Neutral to Overweight. We will explain why we believe this should be considered as new buying opportunities, rather than being avoided.
This is an extract from our report. To get the full report, click on the link below.
Recent CIO view: New buying opportunities in US Treasuries
The recent rise in US Treasury yields was driven by resilient growth in the US, Japan loosening yield curve control, and increased Treasury issuance. US long-term rates are expected to have peaked or close to peak as the central bank probably reached the end of its rate hike cycle and economic activity is expected to slow. As a result, we upgrade US government bonds to overweight on a 12-month basis, including maturities up to 10 years and have a preference for inflation-linked bonds.
The US economy has just begun to slow with unemployment rate rising and inflation falling. We believe the Federal Reserve medicine is starting to work with the normal lags in monetary policy. We expect a slowing economy and moderate recession in 2024.
In our view, it is likely that the Fed has reached its terminal rate and will hold its target rate steady at 5.5%. We expect a series of rate cuts from Q2 2024 onwards with a cumulative 225 bps until mid-2025. In the Eurozone, a terminal rate of 4.0% (deposit rate) probably has already reached. We do not expect any more rate hike, and we believe rate cuts in the Eurozone may start from 3Q 2024 with a cumulative 100 bps by mid-2025.
Furthermore, we remain positive on European and US quality investment grade corporate bonds. We also continue to like Emerging Markets' sovereign bonds (both local and hard currency).
US TREASURIES: CURRENT ENVIRONMENT
US long-term rates are expected to be nearing a peak in coming months. At the same time, US 10-year treasury yield surged to a 16-year high with a current level around 4.5%. Since 1928, US 10-year treasuries have never posted three consecutive negative annual performances in recorded history.
MARKET OUTLOOK & EXPECTED RISK-RETURNS
• We expect a series of rate cuts from Q2 2024 onwards with a cumulative 225 bps in US until mid-2025. As a result, price and yield being inversely related, we expect positive returns in 2024 and 2025 for US treasury bonds where potentially high single digit or low double digit is possible.
• Over the long-term, we estimate the expected return for US government bonds to be 3.5%. With an annual volatility around 6.5%, US treasuries are ranked within the best risk-return profile among the FI market.
KEY BENEFITS OF LONG-DATED US TREASURIES
• Fixed income portfolios including US treasuries generally outperform portfolios holding only investment grade bonds during a falling rate environment thanks to a greater sensitivity to fall in rate (relative additional capital gain up to 2% depending on the scenario).
• US Government bonds are a great diversification solution within a multi-asset and diversified portfolio. Indeed, long-dated US treasuries are almost always the most decorrelated assets among the main asset classes.
• Also, adding US treasuries into a balanced portfolio tends to:
• Decrease the overall portfolio’s risk (decrease of volatility),
• Improve the portfolio diversification,
• Reduce the maximum potential losses,
• While adding protection, does not substantially weaken the expected return and yield,
• As a result, improve the overall risk-return profile (increase of Sharpe ratio).
HOW TO GET EXPOSURE
• Bond-linked structures on US treasuries allow investors to buy US treasuries at a price lower than the prevailing market price. Together with an enhanced coupon, the breakeven price is even lower though investors must be aware of additional counterparty risks.
• US IG corporate bonds would also benefit from the US treasuries recovery and a fall in rate thanks to similar financial and economic drivers while being more exposed to credit risks.
