Learn About Bonds in a Stock Bear Market
Bonds have a reputation as being a good way to diversify a portfolio that’s heavily invested in stocks, a trait that becomes especially apparent when stock prices fall quickly. However, the diversification benefits largely depend on the type of bonds you own.
Individual Bonds vs. Bond Funds
The first issue to consider is the question of owning 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 since the vast majority of bonds eventually mature at par. While there is always a chance that a bond could default, this risk can be mitigated through a focus on higher-quality issues.
In contrast, bond funds don’t mature but rather 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 market in equities.
U.S. Treasuries: The Best Bet for a Stock Bear Market
Keeping in mind that there are no guarantees in the financial markets, U.S. Treasuries are the bond market segment most likely to perform well when stocks are in a bear market.
During the bear market that ran from October 11, 2000, through March 10, 2003 (the popping of the “dot-com bubble”), U.S. stocks fell 39%, but the yield on the 10-year Treasury note rallied from 4.63% to 3.59%. (Keep in mind, prices and yields move in opposite directions.)
In the next major bear market — January 10, 2008, through March 12, 2009 (the housing/mortgage crisis) — U.S. equities plummeted 45.3%, but the 10-year rallied from 3.91% to 2.89%. As a result, an investor who held an allocation to Treasuries or Treasury funds would have experienced smaller losses to their overall portfolio.
One reason why this is the case is that the stock market often falls due to fears about slowing economic growth, a development that can work to the benefit of Treasuries. Government bonds also tend to benefit from a “flight to quality” when investors grow adverse to risk — as is usually the case when stocks are falling.
Broader Bond Indices in Stock Bear Markets
Anthony Valeri of LPL Financial took a look at 14 stock market downturns from 2004 through 2013 in the firm's January 2014 Bond Market Perspectives. During these downturns, the S&P 500 Index of U.S. equities registered an average return of -12.3%.
In these same time periods, the Barclays U.S. Aggregate Bond Index gained an average of 1.1%. A 60%/40% blend of stocks and bonds averaged a return of -7.0%, 5.3 percentage points ahead of a portfolio invested entirely in stocks.
Valeri notes, "In a few cases, both stocks and bonds declined together. This is a troubling outcome and reflects a failure of diversification, but it is rare. Still, bonds managed to outperform stocks on those occasions."
TIPS and Municipal Bonds: A Toss-Up
Treasury Inflation-Protected Securities and municipal bonds may provide protection in a bear market for stocks — it largely depends on the cause for, and magnitude of, the sell-off. Both asset categories produced gains in the 2000-2003, which featured a sharp decline in stock prices but little concern about the health of the financial system as a whole.
In contrast, 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. Since this worst-case scenario would be accompanied by deflation (falling prices) and not inflation, TIPS prices fell. Municipal bonds also underperformed, as worries about the overall economy fueled fears about a collapse in state and municipal finances.
The takeaway, then, is that funds that invest in these two categories may provide a hedge against a bear market in stocks, but there’s no guarantee — especially if investors become acutely averse to risk.
Bond Market Segments to Avoid When Stocks Fall
In the event of a stock bear market, the bond market segments most exposed to credit risk — as opposed to interest rate risk — are those that are most in jeopardy of price declines. These include — in the order they are most likely to suffer, from least to most — investment-grade corporate bonds (particularly lower-quality issues), high-yield bonds, and emerging market bonds.
Once investors become sensitive to risk, funds invested in these categories will almost assuredly suffer declining principal value. As a result, investors in these areas need to be fully alert to the possibly damaging effects of a bear market in stocks.
The Bottom Line
Bonds, as a group, tend not to fall as far as stocks when the going gets rough, and Treasuries frequently benefit from financial-market turmoil. As a result, 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 segments will suffer losses when stocks fall. The most important takeaway: just because a fund has “bond” in its name doesn’t necessarily mean that it’s low-risk.