Are you looking to strengthen your portfolio’s risk-return ratio? While adding bonds to your portfolio can be a great way of adding diversification and little calm to the volatility, there are a few things that you should know about bonds.
- A bond is a simple debt instrument, similar to an IOU (an acronym for “I Owe You”).
- Buying a bond means lending money to the issuer or borrower; this can be government, corporation, or municipality.
- There are certain risks associated with bonds, such as default risk, interest rate risk, and prepayment risk.
- The ratings associated with the bonds describe their investment grade.
- Bond yields allow the buyer to compute their returns.
Relationship between Bond Prices and Yields
The easiest way to describe the relationship between bond prices and yields is the relationship between demand and supply. When the interest rates rise, the prices of the bonds tend to fall, and when the interest rate falls, the bond prices begin to shoot up. Ideally, investors are keen on investing their money in stable older bonds with higher yields than the fairly new, low-yield bonds.
However, bear in mind that the bond mutual funds and ETFs are directly based on share price, and they are perpetually fluctuating. Bond fund investors need to be more alert about the impact of several external events, such as a bear run in the market. During this time, ideally, the bond fund investors make money due to the positive performance of the bonds.
Amid a bear market, especially post-recession, bond funds could also decline in price in coordination with the stock market.
“Bonds tend to outperform equities in bear market as the central banks tend to relieve the interest rates to stimulate the economy.”
Performance of Bonds during Market Crashes
Certain bonds outperform the others when there is a bear run in the market or the market crashes. To name a few:
1. U.S. Treasuries
U.S. Treasuries are ideally considered a great fixed-income investment to help hedge losses when equity markets are in a bear run. Irrespective of the fiscal health concerns of the country, Us Treasuries are considered a “Safe Haven” in terms of timely payment of principal and interest amount.
2. TIPS and Municipal Bonds
The performance of TIPS (Treasury Inflation-Protected Securities) and municipal bonds largely depend on the cause and magnitude of the market crash. Hence, the result of TIPS and Municipal bonds may be mixed. For instance, during the 2008 financial crisis, when the markets had a bear run, the TIPS and Municipal Bonds underperformed. The breakdown of the global banking system, fueled by fear of a collapse in municipal and state finances, led to the underperformance of TIPS and Municipal Bonds.
3. High-Yield Bonds
Well, high yield is often the most tempting; however, with high reward comes high risk. Hence, be mindful when investing in mutual funds, ETFs, and high-yield bonds. High-yield bonds are generally issued by corporations that have a greater risk of default, resulting in investors demanding higher rates on these bonds. During market crashes, the weaker corporations are at greater risk of default than the strong corporations. This is why high yield bond prices can fall during a market crash.
4. Emerging Markets Debt
The Emerging Market Debt comprises bonds that are issued by an entity with relatively high default risk. Hence, similar to high-yield bonds, these are riskier. However, the issuing entity with emerging market debt is the country and not a corporation. It is not an ideal investment at the time of market crashes.
Why do bonds do well when the market crashes?
Similar to the supply, demand approach, the bonds tend to do well when the market crashes as they become more in-demand than stocks. The risk associated with owning equity of the company is generally higher than lending money to the company through a bond. Uncertainty and volatility lead to more investors shifting towards the fixed-income guarantee bond market over the stock market. Out of all the bonds, the U.S. Treasuries are considered the safest as they gain from the “flight to quality” phenomenon, which became prominent during the time of the market crash. When the market crashes, the investors flee to the relatively safer investments.
Are bonds a good investment during a bear market?
When the market shows a bearish run, it does not necessarily mean recession or financial crisis. However, when the market begins to crash, the bond prices start to rise. Bonds tend to have an inverse relationship with the stock market, meaning that when the stock market rises, the bond prices fall, and vice-versa. The question might have multiple answers depending on different variables; however, one must remember that financial markets have no guarantees.
What is a bear market? A bear run in the market is when the equity prices are falling and often results in panic selling by most of the retail investors. A market is considered bearish when the market index falls by 20% or more within two months.
“Buying fixed income instruments is a great way to hedge your portfolio.”
Yes, bonds can be a great investment when the stock market crashes due to their cushioning or hedging properties. However, it is imperative to understand that not all bonds perform the same way in times of crisis. Ideally, diversification into bonds aids in overcoming the overall negative impact of the market crash. It is only wise to broadly diversify your portfolio as per your risk tolerance and investment capacity.