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Today’s article is about bonds, and I do hope that it will clear some things out!
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Bonds can be a good way to diversify a portfolio that’s heavily invested in stocks, especially when stock prices are falling quickly. Generally speaking, U.S. Treasuries are among the most popular safe havens, and municipal bonds and Treasury Inflation-Protected Securities may also provide protection. But a lot depends on the cause of the bear market.
Keeping in mind that there are no guarantees in the financial markets, U.S. Treasuries are generally said to be a good fixed-income investment to help cushion losses when stocks are in a bear market.1
The stock market often falls due to fears about slowing economic growth, a development that can work to the benefit of Treasuries. Government bonds tend to benefit from a “flight to quality” when investors grow averse to risk.
Broader Bond Indices in Stock Bear Markets
Anthony Valeri of LPL Financial took a look at stock market downturns through 2015. The S&P 500 Index of U.S. equities declined by an average of 16% from top to bottom through the downturns, in the past 50 years.
During a 2014-2015 downturn, the broad stock market declined by 4.1%. The Barclays U.S. Aggregate Bond Index gained an average of 2.1% during one month in January 2015, when stocks were still down.
Valeri notes, “In a few cases, both stocks and bonds declined together. This is a troubling outcome and reflects a failure of diversification, but it is rare. Still, bonds managed to outperform stocks on those occasions.
Valeri suggests high-quality bonds as an offset to stock losses, but warns that bonds don’t perform similarly in every decline and may still experience volatility.
TIPS and Municipal Bonds: A Toss-Up
Treasury Inflation-Protected Securities and municipal bonds may provide protection in some bear markets, but be careful not to jump the gun. It largely depends on the cause for, and magnitude of, the sell-off. Both asset categories produced gains in 2000-2003, which featured a sharp decline in stock prices but little concern about the health of the financial system as a whole.
In contrast, the 2008 bear market was—at its depth—accompanied by concerns about a breakdown of the global banking system and the possibility of an economic depression. Since this worst-case scenario would be accompanied by deflation (falling prices) and not inflation, TIPS prices fell. Municipal bonds also underperformed, as worries about the overall economy fueled fears about a collapse in state and municipal finances.
Funds that invest in TIPS and municipal bonds may provide a hedge against a bear market in stocks, but there’s no guarantee—especially if investors become acutely averse to risk.
Bond Market Segments to Avoid When Stocks Fall
In the event of a stock bear market, the bond market segments most exposed to credit risk—as opposed to interest rate risk—are those that are most in jeopardy of price declines. In the order they are most likely to suffer, from least to most, this includes…
- Investment-grade corporate bonds
- High-yield corporate bonds
- Emerging market bonds
Once investors become sensitive to risk, funds invested in these categories will almost assuredly suffer declining principal value. As a result, investors in these areas need to be fully alert to the possibly damaging effects of a bear market in stocks.
Individual Bonds vs. Bond Funds
One decision to make is whether to own individual bonds or bond funds. Someone who builds a portfolio of individual bonds is unlikely to see significant performance variability in a stock bear market since the vast majority of bonds eventually mature at par. While there is always a chance that a bond could default, this risk can be mitigated through a focus on higher-quality bonds.
In contrast, bond funds are valued based on a share price that fluctuates perpetually. As a result, investors in bond funds need to be more alert to the impact of external events such as a down stock market.
The Bottom Line
Bonds, as a group, tend not to fall as far as stocks when the going gets rough, and Treasuries frequently benefit from financial-market turmoil. As a result, diversifying into bonds can provide a cushion that helps protect investors from the full impact of a stock market downturn. However, it’s essential to be alert to the fact that certain bond market segments will suffer losses when stocks fall. The most important takeaway: just because a fund has “bond” in its name doesn’t necessarily mean that it’s low-risk.
This website www.financial–minimalist.com does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
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