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Worried about stocks? Use U.S. bonds as a cushion Add to ...

You can worry about a market pullback, or you can do something about it – and one idea for doing something about it is to invest in U.S. Treasury bonds.

Sure, Treasuries aren’t exactly hot items these days. The yield on the 10-year Treasury bond has risen to about 1.9 per cent, up from 1.4 per cent in July. As yields rise, prices fall, leaving investors with losses.

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As for being attracted by the cash payouts, the enticement isn’t much: The yield on the 10-year bond is lower than the 2.1 per cent yield offered by the S&P 500. And the yield on the two-year bond is a mere quarter of a percentage point.

But U.S. bonds do offer one significant upside: As Sober Look (via Abnormal Returns) noted, U.S. Treasuries have been zigging when the market zags, offering what strategists call negative-, or anti-correlation.

“What’s particularly interesting about long-dated treasuries as a hedge is that the anti-correlation increases during periods of stress in the financial markets,” the blogger said.

That is, longer-term bonds perform well when investors worry about the economy and stock markets – and so that’s where the hedge kicks in. If markets continue to rise, great. But if the bull market is interrupted by a flareup of the euro zone debt crisis, an economic setback in China or a U.S. dip back into recession, bonds will provide a nice cushion.

“Very few hedging instruments have the ‘optionality’ that kicks in at the time when one really needs it,” Sober Look said. “Equity options and credit instruments (such as CDX) were not nearly as effective, particularly given the cost of decay/negative carry.”

For Canadian investors, U.S. bonds also provide a hedge against the Canadian dollar. That is, when markets turn volatile, the U.S. dollar tends to rise against the loonie as investors look for shelter – providing a potential currency gain on top of the bond-price gain.

Follow on Twitter: @dberman_ROB

 

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