How Investors Can Cope With Bond Market Declines

Why is the bond market down?

Suffice it to say that 2022 has not been a good year for the bond market thus far. There are several reasons for this.

Monetary policy

The Federal Reserve plans to end easy-money policy and raise interest rates. When interest rates rise, investors in the primary market earn higher coupons on new bond issues. This generally means outstanding bonds in the secondary market are worth less. The market has been pricing in multiple interest rate hikes all year, which is reflected in total returns, and one reason the bond market is down.

Inflation

Inflation has been soaring due to fiscal stimulus which put a lot of cash in people’s pockets and a beleaguered supply chain which has been unable to keep pace with demand. When inflation is high, and bond yields are low, the real yield (inflation-adjusted) can be negative. Right now, real yields are -4%! This may cause some investors to rethink their investment strategy as it relates to fixed income.

Real yields as measured by the spread between the 10 Year Treasury Rates and Core CPI.

Darrow Wealth Management, YCharts

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The economy

The Federal Reserve is planning to raise interest rates aggressively to combat inflation. Getting inflation under control quickly without damaging the economy is not a simple task. There is concern that if the Fed raises rates too fast it could trigger an economic downturn or perhaps even a recession.

When investors have concerns about the economic outlook, it’s not just a matter of selling stocks and buying bonds or vice versa. Stocks are much better than bonds for combatting inflation over time, but when there’s a risk-off sentiment, bonds outperform. Right now, fixed income is outperforming stocks by being less negative on a relative basis.

Right now, like always, there are multiple narratives at play in the markets. But the primary reason bonds are down this year is because the Federal Reserve is going to be raising rates.

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Do Bonds Go Up When the Market Crashes?

Generally, but not all the time. The bonds that do best in a market crash are government bonds such as U.S. Treasuries; riskier bonds like junk bonds and high-yield credit do not fare as well. U.S. Treasuries benefit from the "flight to quality" phenomenon that is apparent during a market crash, as investors flock to the relative safety of investments that are perceived to be safer. Bonds also outperform stocks in an equity bear market as central banks tend to lower interest rates to stimulate the economy.

How to Evaluate Bonds in a Bear Market

Bonds with fixed interest rates can weather just about any market conditions. That said, they’re not infallible. In the event of default, bondholders will find themselves holding the bag. This makes it extremely important to evaluate bonds beyond their par value or an attractive interest rate. Investors need to look at bond ratings.

Bond ratings fall into a range of creditworthiness scores, determined by the three major independent ratings agencies: Standard & Poor’s, Moody’s Investor Services and/or Fitch Ratings Inc. Investment-grade bonds are those with low likelihood of default, even in times of economic distress. Below-grade (or junk) bonds are those with a high risk of default: a risk that climbs higher in times of turmoil. Before purchasing a bond, always look at the issuer and the rating.

Investors also need to be mindful of bond covenants, which spell out the terms and conditions of a bond. Companies that can’t or won’t adhere to the covenant of the bond risk default. These are stipulations for how the company must behave or perform and can be restrictive or affirmative. For instance, a bond issuer might fall into default if they exceed a certain debt-to-equity ratio or if they fail to renew an insurance policy. Covenants vary from bond to bond, company to company.

While it’s easy to find yourself tempted by a high-yield bond at a time when stock markets look bearish, recognize that there’s more to a bond investment than the coupon payments. A bond that looks too appealing might just be too good to be true.

2. Prepare for—and Limit—Your Losses

To invest with a clear mind, you must grasp how the stock market works. This permits you to analyze unexpected downturns and decide whether you should sell or buy more.

Ultimately, you should be ready for the worst and have a solid strategy in place to hedge against your losses. Investing exclusively in stocks may cause you to lose a significant amount of money if the market crashes. To hedge against losses, investors strategically make other investments to spread out their exposure and reduce their risk.

Of course, by reducing risk, you face the risk-return tradeoff, in which the reduction in risk also reduces potential profits. Downside risk can be hedged to quite an extent by diversifying your portfolio and using alternative investments such as real estate that may have a low correlation to equities. Having a percentage of your portfolio spread among stocks, bonds, cash, and alternative assets is the essence of diversification. Every investor’s situation is different, and how you divvy up your portfolio depends on your risk tolerance, time horizon, goals, etc. A well-executed asset allocation strategy will allow you to avoid the potential pitfalls of placing all your eggs in one basket.

No or Limited Correlation

Stocks generally decline when the economy goes into a recession. Interest rates typically fall in a recession, which is generally bullish for bonds, so they should rise. However, a recession may be bad for high-yield bonds whose issuers may not be able to make interest payments in an economic downturn, so high-yield bonds decline.

State tax receipts also decline in a recession, raising fears of default in lower-quality municipal bonds, so those can decline too. On the other hand, U.S. Government debt and high-quality bonds issued by blue-chip companies are considered safe havens in a recession and may rise.

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