Portfolio Allocation and Bonds in a Low-Yield World

The investment firm AQR recently produced a paper discussing how to allocate portfolios in a world of zero interest rates. In particular, they asked whether bonds have a role in a portfolio when interest rates are near zero. Their answer is bonds do have a role, but it is a narrower one than in the past. The paper is available for free download here.

Some measures of expected excess returns are low relative to history for bonds, as well as for equities. But tactical timing has an unimpressive track record, especially when based solely on valuation, and humility is therefore warranted in sizing tactical tilts. Even in a low yield environment, there are plausible scenarios where yields could go much lower.

While bonds should not be considered risk-reducing hedges, evidence does suggest they can remain useful diversifiers in many market environments. Investors should be cautious about forgoing potential diversification benefits, both within bond portfolios and across asset classes.