What Role Should Treasuries Play in a Portfolio?

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Christine Benz: Hi, I'm Christine Benz for Morningstar. With 10-year Treasury bonds yielding less than 1% today, investors may be grappling with what role, if any, these bonds play in a portfolio. Joining me to discuss this topic is Alex Bryan. He's Morningstar's director of ETF Research in North America. Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's discuss the first quarter. We saw Treasury bonds really rally. Yields declined quite a bit. So let's discuss some of those forces that contributed to those market effects.

Bryan: I think there's really two reasons why Treasuries did so well in the first quarter. Number one, investors flocked to Treasuries during the coronavirus sell-off earlier this year due to Treasuries' perceived safety. And then secondly, the Fed has aggressively cut interest rates in order to stimulate the economy, and it tends to do that--cut interest rates--during periods of market turmoil. And when rates go down, that tends to raise the price of Treasury bonds. I think both of those effects have played into that really strong performance we saw earlier this year.

Benz: How about in the second quarter, when riskier assets rallied? How did Treasuries do then?

Bryan: In the second quarter, Treasuries provided a small positive return, but they did underperform the broader U.S. investment-grade bond market. Because in the second quarter ,credit risk was rewarded. So corporate bonds and stocks also tended to do quite well as the market started to rebound, but Treasury still held up but just didn't do quite as well as some of those riskier areas of the market.

Benz: Going back to the first quarter, this is one of many periods where we've seen Treasuries really hold their ground quite well in a period where equities are struggling. The question is: With starting yields as low as they are today on Treasuries, I think some investors are reasonably questioning whether that sort of positioning as ballast in investors' portfolios will hold going forward. What's your take on that question?

Bryan: Well, I think Treasuries can still serve that role as a ballast to equities. They can still diversify equity risks because, if the last 10 years have really taught us anything, it's that if you think rates can't go any lower, they always can. There's always a chance the Fed could move rates into negative territory if they need to. But I think the reason why Treasuries offer such a great defensive counterweight to stocks is that they're safer than just about any other alternatives. So they're always going to be attractive to investors in risk-off periods.

And the second reason I think they work really well as ballast is they tend to rise in price when the Fed cuts rates, and the Fed likely cuts rates when things are bad--when the economy is not doing so well, stocks aren't doing so well. So even though you're not really getting paid all that much to hold Treasuries, Treasuries can still provide some much needed lift in periods when stocks aren't doing quite as well.

Benz: Those low yields, though, do tell us something about what to expect from bonds, from the asset class, over the next decade or so. And so let's talk about that--what bonds tell us about what we can expect in terms of total return. And then just talk about the implications for other asset classes as well.

Bryan: When the yield to maturity on the 10-year is below 1% as it is now, it's telling you you're not really getting paid much to hold these bonds. Your expected returns are near historic lows. That's very obvious with bonds because they have a published yield to maturity. But it's important to keep in mind that virtually all investments are priced relative to Treasuries. So when yields on Treasuries are low, expected returns on other assets are low as well.

We don't see this directly with stocks because they don't have a published yield to maturity, but we do see it indirectly in stock valuations, which are high relative to where they've been historically. That suggests that the market has lower expected returns for stocks going forward than it has had for them in the past. So I think that's really important to keep in mind, but there's no question that expected returns today are lower than they were 10 years ago.

Benz: Let's talk about Treasuries in a portfolio context. I think some investors might say, "Well, I don't necessarily want to own a Treasury-only fund." But you don't necessarily have to own a Treasury-only fund to get exposure to Treasuries. So are there any more sort of diffuse ways to obtain Treasury exposure and exposure to other types of bonds as well?

Bryan: Absolutely. One fund that we really like is Vanguard Total Bond Market ETF, ticker BND. This fund basically provides broad exposure to the U.S. investment-grade bond market. So it includes Treasuries, agency mortgage-backed securities, and corporate investment-grade bonds. Treasuries only represent about 42% of that portfolio, but this overall is a very conservative portfolio that has almost two thirds of its assets in bonds that are rated AAA. Its inclusion of corporate bonds and agency mortgage-backed securities allows it to offer higher expected returns in the Treasury-only portfolio, and the additional risk really isn't too bad.

But I think this is a really good, solid core bond holding because, one, it's low cost. But secondly, it is fairly conservative. So, in periods when stocks haven't done quite as well, this fund has been able to offer some much needed ballast to a portfolio and has tended to offer a negative correlation with stocks. I think it will likely continue to offer that diversification relative to stocks, but it's important to have realistic expectations for your bond holdings. They're not going to be able to provide really strong returns as they have over the past decade going forward. It's important to really focus on bonds for the purpose that they're supposed to serve, which is defense. And I think they'll continue to play that, but perhaps with a little bit less upside than in the past.

Benz: Alex, it's always great to get your perspective. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.

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