Long-term Treasurys still viable option: The D. E. Shaw Group

US Treasury bonds with longer maturities remain effective hedging instruments against inflation in the current low rate environment, according to The D. E. Shaw group, a New York-based investment firm, suggesting long-term US yields may have room to decline further.

The rise in US Treasury yields over the past few months reflect investor concerns about inflationary pressure. But in the medium- to long-term, the US government bonds of longer maturities will become effective hedging tools, said Brian Sack, The D. E. Shaw group’s director of global economics and a member of its discretionary macro trading unit.

"In the recent low rate environment, a viable strategy may be to move further out the US Treasury yield curve, where volatility and correlation properties have held up better relative to shorter maturities," 

"Our view is that government bonds and US Treasury securities, in particular, remain a viable portfolio hedge, particularly when inflation prospects are stable. But in a low rate environment, we think that’s demonstrably true only further out the yield curve."

His remarks come as investors are increasingly doubtful about the role of bonds as an inflation hedging tool in the record-low interest rate era. Sack said in a written interview with Market Insight, conducted on the sidelines of the ASK Conference 2021 hosted by The Korea Economic Daily on May 12.

Founded in 1988, The D. E. Shaw gained its name for quantitative investing. As of March 2021, the investment group had more than $55 billion in investment and committed capital.

The following is a transcript of the interview.

▲Government bonds have long been seen as a key hedging tool for investors. How did that hedging role play out at the onset of the Covid-19 pandemic?

"In recent decades, investors have used Treasuries as safe haven assets in their portfolios because these bonds have tended to rally when equities sell off.  However, in the years leading up to the pandemic, the investment community grew increasingly concerned about the effectiveness of these bonds as hedging instruments in the face of low yields, a situation that might reduce their room to rally in a risk-off event."

"Despite those concerns, when the pandemic hit and the market de-risked in February and March 2020, we saw US Treasury yields decline more than might have been expected based on their historical betas, meaning their perceived hedging properties held up well."

(Note: A beta less than 1 indicates that the investment is less volatile than the  benchmark.)

▲So what have you observed since the outset of the pandemic?

"Following that sharp decline in yields at the outset of the crisis, concerns about potential hedging properties of these bonds only grew."

"One thing we observed is that the beta of shorter-term US Treasury yields to equities decreased meaningfully. The volatility of the two-year yield backed off dramatically because short-term interest rates had dropped to the lower bound and were expected to stay there, so there was limited room for the two-year yield to move. The observed decrease in the beta of yields to equities at shorter maturities was largely a result of that drop in volatility."

"However, we observed that the beta held up better at longer maturities, as a result of both correlation and volatility holding up relatively well, given that beta reflects both of those factors."

"We believe there’s a fundamental economic reason for the durability of longer-maturity correlations: when short rates are constrained by the lower bound, central banks tend to use policy guidance that extends out over several years and initiate asset purchases. Those tools project bonds’ hedging-friendly correlation properties out to longer maturities."

▲Do you have any thoughts on whether government bonds can continue to serve as portfolio hedges?

"Our view is that government bonds and US Treasury securities, in particular, remain a viable portfolio hedge, particularly when inflation prospects are stable. But in a low-rate environment, we think that’s demonstrably true only further out the yield curve, where correlation and volatility have held up better, and where the zero bound is less constraining."

▲Do you see any potential risks to this approach?

"I would note two risks in particular."

"One is that if yield curves were to grind lower to the perceived lower bound even at longer maturities, their hedging performance would most likely be impaired.  We saw this play out in 2020 in the behavior of yields in Germany and in Japan."

"The yield curves in those two countries had much less room to decline during the risk-off period, and that was the case even further out the yield curve in those markets."

"The other risk to highlight is that of a meaningful shift in the inflation environment. Should inflation expectations increase and become unanchored, and that becomes viewed as a negative for risk assets, we could see correlation properties shift, affecting the hedging properties of government bonds. We have in fact seen some shift in the correlation in recent months, in part reflecting investors’ concerns about higher inflation prospects in the United States."  

"However, looking beyond the near term, I anticipate the Federal Reserve keeping inflation well-controlled and consequently, the favorable hedging properties of Treasuries gradually returning."

Write to Jung-hwan Hwang at jung@hankyung.com
Yeonhee Kim edited this article.