Bond Bear Market Guide

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While it's impossible to predict where the financial markets will stand in the future, the low-interest rates and yields of the pandemic period—and the need for the U.S. Federal Reserve to begin increasing interest rates—indicate that bonds are destined to produce lower returns in the years ahead.

To protect their portfolios from low to negative bond market returns, investors should mitigate the risks of a downturn. Here are some investments to consider, and some not, if a bear takes a swipe at bonds.

Actively Managed Funds

Many investors prefer index funds for their low costs and relative predictability. A bond bear market is a reason to consider actively managed bond funds if you decide you need to stay in bonds.

Active managers typically charge more in fees than their passively managed counterparts, but they can also shift their portfolios to reduce risk and capture values as opportunities permit.

Try to stay focused on low-fee funds with a long-tenured manager and a strong track record.

In this way, investors benefit from a professional manager taking steps to offset the impact of a bear market.

Unconstrained Bond Funds

"Unconstrained" is a relatively new name for funds in which the manager can "go anywhere" in terms of credit quality, maturities, or geographies. This is the next step from active management since active funds can be limited to a particular market area.

Unconstrained funds have no such restrictions. A wider range of opportunities, at least in theory, should equate to a greater number of ways to sidestep a market downturn.

Floating Rate and International Bonds

Rather than paying a fixed rate of interest, these bonds have yields that adjust upward with prevailing rates. While not a perfect guard against poor market performance, floating-rate bonds can be expected to perform better than typical fixed-rate investments in a down market.

Since the international economies may not be affected by the same set of circumstances as the United States, they may not necessarily perform as poorly in a bear market.

Before investing in international corporate bonds, be sure to speak to your financial advisor. You inherit currency and sovereign risk when investing internationally.

In an increasingly connected global economy, foreign bonds could take a hit that's the same or worse than what occurs in the U.S. market. The best approach is to monitor how the international markets perform relative to the United States.

Developed markets have more stability than emerging markets. Developed-market corporate bonds may be worth considering as a potential performance source if the U.S. bond market dives.

Individual Bonds

Unlike bond funds, individual bonds have a set maturity date. This means that no matter what happens in the bond market, investors are guaranteed to receive a return of principal unless the issuer defaults on its debt.

Bond funds are more likely to experience persistent valuation pressure in a rising rate environment, whereas individual bonds held to maturity will (usually) deliver the par value. If rates are rising, prices are inevitably falling, making an opportune time to purchase more bonds to hold until maturity.

Funds are more likely to default, where individual bonds held to maturity will (usually) deliver the par value. If rates are rising, prices are dropping. It would be an excellent time to purchase more bonds to hold until maturity.

Bonds With Short Maturities

Short-term bonds aren't exciting, and they don't offer much in the way of yield. However, they are very conservative investments unlikely to see substantial losses in a bear market if the investor is worried about interest rate risk.

Short-term bonds won't necessarily make money in a bear market, but they work better to preserve capital and prevent the significant losses resulting from investing in a fund that's dependent on bond yields in a rising-rate environment.

In contrast, long-term bonds have a much higher interest rate risk than short-term bonds, which means that rising interest rates have the potential to crush their performance results. For instance, from May 1 to July 31, 2013, the bond market was hit hard as the yield on the 10-year note soared from 1.64% to 2.59% (keep in mind that prices and yields move in opposite directions).

During that period, the Vanguard Long-Term Bond ETF (BLV) was hit for a loss of 10.1%, while the Vanguard Intermediate-Term Bond ETF (BIV) declined 5.0%. However, in the same period, the Vanguard Short-Term Bond ETF (BSV) fell just 0.6%.

Bonds Instead of Bond Proxies

One popular course of action in the era of low rates has been to look for opportunities in dividend-paying stocks and hybrid investments such as preferred stocks and convertible bonds.

The best bet is not to take risks associated with the stock market—even in conservative investments—unless you have the tolerance to withstand short-term losses.

These investments performed very well from 2010-to 2012. Coined "bond proxies" by the financial community, they tend to have a higher risk than bonds, and they are likely to underperform when rates are rising.

Avoid High-Risk Assets

If the expected downward adjustment in bond prices occurs gradually over an extended period, investment-grade corporate and high-yield bonds can likely deliver more performance because of the advantage provided by their higher yields.

However, if the bond market experiences a more rapid sell-off, these assets will likely suffer substantial underperformance. Investors should approach the market with a strategy that is appropriate for either scenario.

Consider funds in these areas, but look for more conservative options, such as short-term high-yield bond funds, which offer the combination of decent yield and lower interest rate risk, or target maturity funds protected to some extent by their fixed maturity dates.

The Bottom Line

Rather than taking on more risk to pick up extra returns in a bond bear market, it's always best to take on the more conservative approach of protecting your capital.

While a bear market isn't a certainty, it is clear that the odds of weaker future returns outweigh the odds of returning to the kind of high-return environment that characterized 2010-2012. Investors—particularly those in or near retirement—should consider ways to protect their portfolios from a financially dangerous scenario.

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