Can bonds continue to play defense and provide income when yields are at historic lows? We think so. By strategically pairing interest-rate risk with diverse sources of credit risk, investors can improve the risk, return and income profiles of their portfolios.

Low Yields and High Volatility Will Stick Around

Investors’ concerns are understandable. Central banks have driven interest rates to record lows in an effort to prime an economic recovery during the pandemic. Those low and negative yields could last a long time. In fact, the US Federal Reserve indicated in mid-September that it will peg interest rates near zero through at least 2023.

At the same time, volatility is almost certain to ramp up in the coming months because of a possible second wave of COVID-19 cases; November’s US elections, which could be contested; rising geopolitical tensions and ongoing trade wars; and increasingly adversarial Brexit negotiations.

Under these conditions, a bond portfolio must play both defense and offense. It must limit downside risk in volatile markets, and it must generate income and return despite a low-yield environment. Thankfully, the fixed-income market is still positioned to meet both objectives.

Let’s start with the role of government bonds in limiting downside risk.

US Treasuries and German Bunds Still Play Defense

Some market observers have suggested that low and negative yields will hinder government bonds’ ability to provide a buffer against down markets because bond returns will also be low.

We agree that government bond returns will be more muted than in the past because of low yield levels. Indeed, US Treasury returns have been comparatively muted for the last decade, having already reached the lower limits of a downward trend in yields that lasted 30 years.