Understanding When Bonds Protect Your Portfolio—and When They Don't

Financial professionals typically add bonds* to portfolios to help counteract stock market losses. Advisors often use a combination of:

• Short-term bonds (under 5-year maturities)
• Medium-term bonds (5–9-year maturities)
• Long-term bonds (10+ year maturities)

In 2018, however, most bonds had not provided the portfolio protection investors traditionally expected—until very recently.

When Bonds Protect You from Falling Stock Prices

1. When the Economy Goes Into Recession

Why?

The Federal Reserve typically cuts interest rates to stimulate economic growth during a recession. When interest rates fall, bond prices generally rise.

Example

During the market downturn in 2008:

• The stock market declined approximately 36%
• 10-year U.S. Treasury bonds gained about 20%
• The Federal Reserve aggressively lowered interest rates

2. During Periods of Global Uncertainty

Why?

Investors often sell riskier assets and move money into U.S. Treasury bonds because they are considered among the safest investments in the world. Increased demand pushes bond prices higher.

Example

Concerns about an unstable Italian government and its ability to repay debt led investors to sell stocks and purchase U.S. Treasury bonds, driving Treasury prices higher.

3. In a Deflationary Environment

Why?

When prices of goods and services are expected to decline, the fixed income generated by bonds becomes more valuable because it can purchase more in the future. Falling interest rates also tend to increase bond prices.

Example

During the Great Depression in the early 1930s:

• Annual stock market returns ranged from -9% to -44%
• 10-year Treasury bonds gained between 2% and 9% annually

When Bonds Do NOT Protect You from Falling Stock Prices

1. During Inflationary Fears

Why Not?

Inflation concerns generally cause interest rates to rise, which pushes bond prices lower. In addition, the fixed income from bonds loses purchasing power as prices increase.

Example

On February 26, 2018, signs of wage inflation caused investors to sell bonds, driving prices lower. Over the following days, the S&P 500 declined approximately 10%.

When Bonds Can Hurt You in a Rising Stock Market

1. During Stagflation (Slow Growth + Inflation)

Why?

Inflation pushes interest rates higher and bond prices lower. Meanwhile, companies may still increase profits by raising prices, allowing stocks to perform well despite weak economic growth.

Example

In 1980:

• GDP growth was -0.2%
• Inflation reached 13.29%
• The stock market returned 31.74%
• 10-year Treasury bonds returned -2.99%

Investors lost purchasing power due to inflation and experienced negative bond returns at the same time.

What Do We Expect for the Rest of 2018?

Despite the recent move toward slightly lower interest rates, the underlying factors contributing to higher rates remain in place.

Key Factors Supporting Higher Interest Rates

• The Federal Reserve's commitment to raising interest rates
• The Federal Reserve's reduction of Treasury and mortgage-backed security purchases
• International tariffs increasing the cost of goods
• Rising commodity prices
• Wage growth
• Increased borrowing needs by the U.S. government and corporations

(See our March 22, 2018 blog for additional discussion.)

What Can You Do If You're Concerned About Rising Interest Rates?

If you're worried about negative bond performance caused by rising interest rates but still want protection from stock market declines, consider:

Shifting Assets Toward Shorter-Term Investments

Move money from medium- and long-term bonds into:

• Money market funds
• Very short-term notes (under 2-year maturities)

At the time of writing:

• Money market funds were yielding approximately 1.75%
• 2-year Treasury bonds were yielding approximately 2.47%

While these yields are somewhat lower than those of medium- and long-term bonds, they can still keep pace with reported inflation while reducing exposure to significant price declines caused by rising interest rates.

The Bottom Line

Consider reducing potentially significant price risk in medium- and long-term bonds in exchange for slightly lower income—typically about 0.5% to 1% less yield.

The appropriate investment strategy ultimately depends on your unique financial circumstances. We welcome the opportunity to evaluate your specific situation and discuss the best approach for your goals.

What Is a Bond?

A bond is a fixed-income investment in which you lend money to an entity for a specified period of time. In return, you receive interest payments based on the bond's stated coupon rate.

Examples include:

• U.S. Treasury Bonds – lending money to the federal government
• Municipal Bonds – lending money to a city, county, or other municipality
• Corporate Bonds – lending money to a company