Bond Bear Market Guide

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While nobody knows for sure what the future will bring when it comes to the financial markets, today's low yields - and the need for the U.S. Federal Reserve to begin increasing interest rates at some point in the not-too-distant future - indicate that bonds are destined to produce lower returns in the years ahead.

If the next five to ten years indeed usher in an era of low to negative bond market returns, many investors will need to find ways to protect their portfolios from the impact of a downturn.

With that in mind, here’s a brief guide to provide a hint of what may – and may not – work well if bonds enter a bear market.

Focus on Short Maturities, Avoid Long-Term Bonds

Short-term bonds aren’t exciting, and they don’t offer much in the way of yield. However, they are also very conservative investments that unlikely to see substantial losses in a bear market. In contrast, long-term bonds have much higher interest rate risk than short-term bonds, which means that rising interest rates have the potential to crush their performance results.

Consider this: In the period 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, prices and yields move in opposite directions.) During that time 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%.

In the same time period, however, the Vanguard Short Term Bond ETF (BSV) fell just 0.6%.

This helps illustrate that while short-term bonds won’t necessarily make you money in a bear market, they are much less likely to suffer significant losses than their longer-term counterparts. Simply put: if you want to stay safe, stay short.

Avoid High-Risk Assets

Not all segments of the bond market react in the same manner to the same set of stimuli. Over time, for example, sectors with higher credit risk – such as Investment-grade corporate and high yield bonds – have demonstrated the ability to outperform when longer-term yields are rising. There is another factor that can come into play, however: the speed at which yields are rising.

If the expected downward adjustment in bond prices occurs gradually over an extended period, it’s very likely that these asset categories can deliver outperformance due, in part, to the advantage provided by their higher yields. However, if the bond market experiences a more rapid sell-off – such as those that occurred in the early 80s, 1994, and the second quarter of 2013 – then these areas are likely to suffer substantial underperformance.

Investors should, therefore, approach the market with a strategy that is appropriate for either scenario. Consider funds in these areas, but look for the more conservative options – including short-term high-yield bond funds, which offer the combination of decent yield and lower interest rate risk, or target maturity funds, which are protected to some extent by their fixed maturity dates.

Again, playing it conservatively – rather than taking on more risk in an effort to pick up extra returns – will be the name of the game in a bear market.

Don’t Fall Into the Bond-Proxy Trap

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. These investments did, in fact, perform very well in 2010-2012, but make no mistake: the so-called “bond proxies” have a higher risk than bonds, and they are likely to underperform at a time of rising rates. In fact, this is exactly what occurred during the second-quarter of 2013. Investors who look outside of the bond market for income won’t necessarily find safety in these areas.

The best bet: don’t take the risks associated with the stock market – even in would-be “conservative” investments – unless you have the tolerance to withstand short-term losses.

Learn more about the risks of bond proxies here.

Four Investments to Consider

Many investors prefer index funds for their low costs and relative predictability, but a bear market is a reason to consider the following investments:

  • Actively managed funds: Active managers typically charge more in fees than their passively managed counterparts, but they also have the ability to shift their portfolios to reduce risk and capture values as opportunities permit. In this way, investors have the benefit of a professional manager taking steps to offset the impact of a bear market. The best bet: stay focused low-fee funds with a long-tenured manager and a strong track record.
  • Unconstrained bond funds: “Unconstrained” is a relatively new name for funds in which the manager as the ability to “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 area of the markets, whereas 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 bonds: Rather than paying a fixed rate of interest, these bonds have yields that adjusted 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.
  • International bonds: 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. Note, however, that the operative word here is “may.” In an increasingly connected global economy, foreign bonds could very well take a hit that’s the same – or worse- than what occurs in the U.S. market. The best approach, for now, is to monitor how the international markets perform relative to the United States. Developed-market corporate bonds, which held up relatively well in the April-July downturn, may be worth a look in as a source of potential outperformance in the years ahead.

Individual Bonds a Better Bet Than Funds in a Down Market

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. Daniel Putnam of InvestorPlace writes in his August 2013 article, “The Best Way to Invest in Bonds During Retirement,”:

“Individual bonds … offer two key advantages. First, investors who emphasize high-quality bonds with a low likelihood of default are able to minimize or even eliminate the principal losses that can occur with bond funds. Even if yields rise sharply, investors can sleep at night knowing that market fluctuation isn’t going to take a toll on their hard-earned savings. Second, rising rates can actually work to the benefit of investors in individual bonds by allowing them to purchase higher-yielding securities as their current holdings mature. In a negative-return environment, the value of these two attributes can’t be overstated.”

It’s definitely an approach to consider, but be ready to commit the time necessary to do the appropriate research.

The Bottom Line

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

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.