Today’s bond yields are extremely low, and some multi-asset investors may be struggling to rationalize exposure to interest-rate driven assets such as government bonds. But past experience suggests that they can still be effective diversifiers over the near term, even at low yield levels.

As the world battles the COVID-19 pandemic, government bond yields have tumbled. US 10-year Treasury yields fell below 1% for the first time in history in early March, settling in the 60–70 basis-point range. 10-year UK gilt yields have hovered around historical lows of about 20 basis points. Meanwhile, 10-year yields in Japan and Germany have stayed at zero/negative levels, where they’ve been for a few years now.

Given the bleak yield landscape—and the Federal Reserve’s repeated rejections of resorting to negative interest rates—it’s no shock that some investors are questioning the idea of maintaining interest-rate exposure as a diversifier in multi-asset portfolios. After all, how much more can government bonds really have left? And can they still be relied on to diversify against risk assets?

The Low-Interest-Rate Experience: Japan and Germany

While it’s true that government bond returns aren’t likely to be impressive at their current yield levels, our research suggests they may still be effective diversifiers when used tactically.

US Treasury yields don’t have much experience in ultra-low-yield environments: the 10-year Treasury yield has never been negative, and we think negative rates are unlikely. German bunds and Japanese government bonds (JGBs), however, have seen extremely low or sub-zero rates for a few years now.

Since 2010, 10-year JGB yields have been below 1% on more than 2,200 different days. That total includes 475 days with sub-zero yields. German Bund yields dropped below 1% in the second half of 2014, and they’ve remained in negative territory since March 2019.