Are Long-Duration Treasuries the Best Hedge for Equities?

Abstract

The authors study the link between bond maturity and equity diversification in developed economies across the last six decades. Although correlations between equities and interest rates have been largely similar for different bond maturities, yield-curve dynamics have varied considerably across episodes of stock-market stress. All interest rates tend to fall during sharp market crashes, but US, German, and UK yield curves steepened over prolonged downturns, and the Japanese yield curve flattened. As a result, 20-year bonds had estimated returns similar to 10-year bonds during equity downturns in the United States and Germany, were 26% lower in the United Kingdom, and outperformed only in Japan. The diversification gains of maturity extension are linked to macroeconomic factors, including monetary policy, expected inflation, and the shape of the yield curve. Yield curves tend to decline most during conventional easing but steepen considerably, whereas quantitative easing can instead flatten yields. These findings suggest that duration management may be best as an active investment discipline.

TOPICS: Developed markets, financial crises and financial market history

Key Findings

• • Yield-curve dynamics can vary considerably across episodes of stock-market stress. Although all interest rates tend to fall during sharp market crashes, US, German, and UK yield curves steepened considerably over prolonged downturns, and the Japanese yield curve flattened.

• • Long-maturity bonds have offered mixed incremental diversification benefits. Twenty-year bonds had estimated returns similar to 10-year bonds during equity downturns in the United States and Germany, were 26% lower in the United Kingdom, and outperformed only in Japan.

• • Diversification gains of maturity extension are linked to monetary policy. Yield curves tend to decline most during conventional easing but steepen considerably, whereas quantitative easing can instead flatten yields. This suggests that duration management should be an active investment discipline.