Ok, one more bond post. I thought I was done with this little series of bond TAA posts, but based on some feedback and some very astute questions from my subscribers, I decided I needed to do one more.
So, here is the basic question I received, "Aren't you concerned about inflation, fiat currency debasement, etc.? What about gold and commodities?" Usually, my answer to gold and commodities is NO! I don't like dead assets in a portfolio. By dead assets, I mean assets that have zero yield, whether that be in terms of cash flow or coupon payments. It is a personal bias, yes, but backed up with data. In general, over time they don't add anything to a diversified TAA portfolio. In fact they reduce returns and increase drawdowns. Other assets in the portfolio on the risk-on side (real estate and emerging markets for example) usually do as well or better in an inflationary environment.
But what got me thinking this time was that the question came from the risk-off perspective and that it was framed differently. What if bonds are now also a zero-yielding asset? Or, in a world of negative rates, zero-yield assets are the higher-yield option? Yeah, OK. That is a different world and I need to reconsider my original premise. The question for me now is what about potentially adding gold to risk-off types of TAA strategies, specifically TAA bond strategies.
Note: I looked at adding commodities to the risk-off side as well. Like on the risk-on side, they make things worse, not better, in terms of returns and risk. At least for the period studied, 1999 through July 12, 2019.
Let's take a quick look at adding GLD to the UI1 strategy (CRED/GOV) I presented in my last TAA bond strategy post. In this new twist, I add GLD to the list of assets on the risk-off side, the GOV side, of the bond strategy. I call this set of assets GOVH, H for hedge. Thus, during risk-on periods, the strategy is long HYG, BNDX, EMB, LQD, equal weighted, and during risk-off periods the strategy is long SHY, IEF, TLT, GLD, equal weighted. Let's call it the UI1 Hedge strategy for future reference. The table below shows the full period results and comparisons to the other strategies.
Not bad, the addition of GLD definitely didn't hurt, and in fact, it increased returns a little. Now let's look at the various sub-periods. Here you can see in which environments GLD helped.
The addition of GLD helped the most during the period of increasing inflation and commodity prices from 1999 to 2007. It didn't hurt during the low inflation current market cycle, 2008 to now, and it helped a bit during the reflation period from 2012 to 2018 where US 10-year rates more than doubled.
Another thought. Assume an investor ran a portfolio with a 60% allocation to an equity TAA strategy and 40% to this UI1 Hedge strategy. During a risk-off environment, the investor would have a 40% x 25%, or 10%, allocation to gold, which is what many traditional asset allocation approaches recommend. The key difference with this approach is that the allocation to GLD only takes place when conditions warrant and not 100% of the time. Also, these allocations could be easily tweaked to the desired level of "protection".
It would be interesting to look at other zero-yielding risk-off assets as well. Currencies, like the yen vs. dollar, the dollar index, or interest rate instruments like eurodollars could make for interesting options as well. That is a subject for another time.
In short, adding GLD to the enhanced bond TAA strategy helps a bit, doesn't hurt, and maybe protects and enhances returns in a future deflationary/inflation scenario or just in a new normal world of zero- to negative-yielding bonds. I'll be making this change to the strategy in my Economic Pulse Newsletter.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.