Financial professionals typically add bonds* to portfolios to counteract stock market losses. Advisors use a combination of short term (under 5 year maturities), medium term (5-9 year maturities) and long term (10+ year maturities) bonds for this purpose. In 2018, most bonds have not provided the portfolio protection that investors have traditionally expected, until very recently.
When bonds protect you from falling stock price
1) When the economy goes into recession
Because the Federal reserve cuts interest rates to stimulate economic growth. When rates go down, bond prices go up.
Example: During the market downturn in 2008, the stock market was down 36% but 10 yr Treasuries were up 20%, and the Federal Reserve acted aggressively to lower interest rates.
2) In periods of global uncertainty
People sell other investments to buy US Treasury bonds because they are considered the safest investments in the world. When demand for Treasury bonds increases, prices go up.
Example: The recent fear of an unstable Italian government negatively affecting Italian debt repayment and European economic growth caused investors to sell stocks and buy US Treasury bonds.
3) In a deflationary environment
With deflation, future prices of goods and services are expected to go down, so your fixed bond coupon will buy you more. As interest rates go down bond prices go up.
Example: In the early 1930’s, during the Great Depression annual returns for stocks went down between 9% and 44% each year while 10yr Treasuries went up between 2% and 9%.
When bonds DO NOT protect you from falling stock prices
1) When there are inflationary fears
Inflation fears cause interest rates to go up and therefore bond prices to go down. Your fixed bond coupon will buy fewer goods and services in the inflationary environment.
Example: On February 26, 2018 signs of wage inflation caused investors to sell bonds, making prices go down. The S&P 500 went down 10% over the next few days.
When bonds Can hurt you in an Up stock Market
1) No-growth economy and inflation (stagflation)
Inflation causes rates to go up and bond prices to go down. Your fixed bond coupon can’t keep up with the increased prices of goods and services. However, stock prices may still increase because companies are benefiting from their ability to charge customers higher prices.
Example: In 1980, GDP growth was -.2% and inflation hit 13.29 %. The stock market returned 31.74%, which was well above the inflation rate. However, 10 yr Treasury bond returns were -2.99 which meant investors lost money two ways, 13% lower purchasing power due to inflation, and actual negative bond returns.
What do we expect from the rest of 2018?
Despite the recent move to slightly lower rates, the underlying contributors to higher interest rates aren’t going away anytime soon. (See our blog March 22, 2018
• The Federal Reserve’s commitment to raising interest rates
• The Federal Reserve’s shift away from buying Treasuries and mortgage backed securities
• International tariffs raising the prices of goods
• Rising commodity prices (How much is it costing you to fill your gas tank?)
• Wage growth
• Larger borrowing needs by the U.S. government and corporations
If you are worried about negative bond performance due to rising interest rates, but still want some protection from falling stock prices, what can you do?
Take money out of medium and longer term bonds and invest in money market funds and very short term notes (under 2 year maturities). Currently, money market funds are yielding about 1.75% and 2 year Treasuries are yielding 2.47%. While the yields on these very short term bonds and money market funds are lower than medium and long term bonds, they still keep up with reported inflation. The bottom line: reduce potentially significant price risk on your medium and long bonds in exchange for slightly lower income (1/2% to 1% lower yield).
Please keep in mind, the right investment strategy depends on your overall personal financial situation. We welcome the opportunity to evaluate your specific situation alongside you.
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