By learning more about the types of bonds, bond mutual funds, and bond exchange-traded funds (ETFs), investors may be able to benefit when stock prices are falling.
Bonds and Stock Bear Markets
A bear market means that stock prices are declining and market sentiment is pessimistic. Bonds can be a good investment during a bear market because their prices generally rise when stock prices fall. The primary reason for this inverse relationship is that bonds, especially U.S. Treasury bonds, are considered a safe haven, which makes them more attractive to investors than volatile stocks in such times. In addition, to reduce negative economic impact, the Federal Reserve is often a buyer of U.S. Treasury bonds as part of monetary policy that stimulates the economy by lowering interest rates.
How Bonds Perform in a Bear Market
It’s important to note that capital markets, which include bond and stock investors, are generally forward-looking mechanisms. This means that price movement today reflects expectations of economic conditions in the future. If investors expect a recession, for example, bond prices are generally rising and stock prices are generally falling. This also means that the worst of a stock bear market typically occurs before the deepest part of the recession. The majority of price increases for bonds, and the lowest yields, typically occur before and leading up to the deepest stage of recession. This was the case during the 2001 recession, as well as in late 2008, which was the deepest point of the Great Recession. We can also see this with the most recent 2020 stock bear market and recession.
Bond Prices, Yields in a Recession
The relationship between bond prices and bond yields is one of supply and demand. If interest rates are rising, the price of today’s bonds are generally falling. Who wants to buy the older bonds with lower yields when they can get the newer ones at higher yields? In turn, when interest rates are falling, bond prices are generally rising. This is because the older bonds with higher yields are more attractive to investors than the newer, lower-yielding ones.
Types of Bonds in a Bear Market
Some bond types tend to perform better than others during stock bear markets.
U.S. Treasuries
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. Despite concerns about the fiscal health of the country, U.S. government bonds are seen as being among the world’s safest in terms of the likelihood that their interest and principal is paid on time.
TIPS and Municipal Bonds
Treasury Inflation-Protected Securities (TIPS) and municipal bonds may provide protection in some bear markets, but results could be mixed. Performance of these bond types depends on the cause for, and magnitude of, the bear market sell-off. For example, 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. Because this worst-case scenario would be accompanied by deflation (falling prices) and not inflation, TIPS prices fell at that time. Municipal bonds also underperformed, as worries about the overall economy fueled fears about a collapse in state and municipal finances.
High-Yield Bonds
Be careful when investing in high-yield bonds and the mutual funds and ETFs that are based on them during bear markets and recessions. The exposure inherent with this type of bond is called credit risk, which is the threat of the underlying bond issuer defaulting on its own debt. High-yield bonds are generally issued by corporations or municipalities that carry greater risk of default, which is why investors demand higher rates on these bonds. During a recession, the weaker corporations are at more risk of default than in more favorable economic environments. For this reason, high yield bond prices can fall during a recession.
Emerging Markets Debt
For reasons similar to the disadvantages of high-yield bonds, emerging market sovereign debt consists of bonds issued by an entity that has relatively high risk of default. Except in this case, it’s a country instead of a corporation. Because of this risk, emerging market debt is not typically a good investment choice during a recession.
Individual Bonds vs. Bond Funds
One decision to make is whether to invest in 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 because the vast majority of bonds eventually mature at par, or face value. 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 mutual funds and bond ETFs 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. During a stock bear market, bond mutual funds could turn in a positive performance.
The Bottom Line
Bonds can be a good investment during a stock bear market because of their hedging properties. However, investors are wise to understand that not all types of bonds perform in the same way during a financial crisis. Also, there’s no sure way to know how a bear market today will be different or similar to bear markets in the past. In general, 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 products, including bond funds, are likely to suffer losses when stocks fall. It’s important to note that no one can accurately predict how bonds or stocks will perform in the short term—or in a recession. For most investors, a balanced portfolio of broadly diversified stock funds and bond funds, suitable for your risk tolerance and investment objective, is wise.
