Bonds have long served investors of all sizes incredibly well. But not all bonds are a safe bet, as some bonds can be riskier than other types of bonds. In general, financial professionals advise investors to have bonds and other, less volatile securities in their portfolio during a recession. But why do they advise individuals to have different types of bonds? What makes bonds safe during a recession? Here’s why.
At any given moment, an investment portfolio is comprised of many different assets, from stocks, ETFs, commodities, and of course, bonds. All of the components of a portfolio are essential for growth and sustainability. However, the portfolio’s returns can be weighed down significantly by equity investments during a recession. This is especially true when it comes to certain sectors in the market such as leisure, hospitality, and real estate, which is why general diversification is an important part of building a portfolio.
Having bonds in a portfolio is a relatively safe alternative to owning high-risk stocks during a recession. The main reason why bonds are a preferred investment during a recession instead of stocks is due to the value they bring to a portfolio. During a recession, the stock market is often negatively impacted by volatility and declines. Although bonds are a preferred investment during a recession, not all bonds are made equal, there are different types of bonds.
There are several types of bonds you can invest in:
Agency bonds, savings bonds, mortgage bonds, and more, but we will focus on the most used bonds. The most common are US treasury bonds, municipal bonds, and corporate bonds. One of the most favorable types of bonds during a recession is US treasury bonds (also called T-bills).
These types of bonds are the safest bonds you can purchase, as they are guaranteed by the US federal government. T-bills are also considered to be a “risk-free” investment due to the risk of the federal government defaulting on the bonds being essentially zero. Other countries also have the same types of bonds but are not considered to be “risk-free” investments. Due to their low risk, they offer the lowest returns.
The next most commonly used bonds are municipal bonds, which are bonds that are issued by local governments. With the bonds, municipalities can finance infrastructure in a particular city. Municipal bonds give slightly higher returns than T-bills but are also slightly risker.
The third most common type of bond is a corporate bond, which can be issued by all types of corporations. Corporate bonds can be much riskier than the other types of bonds mentioned, depending on the company issuing them. Due to having higher risks associated with them, the returns are higher as well. In general, when dealing with corporate bonds, the higher the returns, the higher the risk, and vice versa.
When the stock market is impacted by a recession, corporate stocks take a fast and drastic tumble, while bonds hold their value and will continue to pay out their predetermined interest rates. The reason why this happens is due to the structure of the financial securities. When an individual is purchasing a share in a company, they are purchasing an incredibly small portion of that company.
When the overall value of the company declines, so does the value of the stocks since the value of the stocks is directly tied to the value of the company. The opposite is also true, as the value increases, the stock price increases as well, giving the investors in the stock a return. Keep in mind that the decline in the stock’s price does not always correlate to the same decline in the general value of the company.
The reason why the value of a bond does not decline at the same rate as a stock in the same company is due to how bonds work. When an investor purchases a bond in a company, government, or municipality, they are lending that institution the money and not purchasing a stake. In exchange, they get a predetermined interest rate.
Loaning an institution money is where the risk comes in while investing in bonds. It is generally accepted that on average, bonds are safer, less volatile, and more predictable than stocks. However, the risk lies in the institution that is issuing the bond. A corporation during a recession can see its stock price decline significantly. Companies may see declining revenue, gross profit, and net income.
As a result, some companies may experience financial hardships that they become unable to pay the interest payments on their bonds. If the company is not able to find the correct financing, it will be forced to file for bankruptcy and as a result of the bankruptcy, the company may no longer be able to pay back the bondholders in full, depending on the circumstances. This is, of course, the worst-case scenario when investing in bonds.
During a recession, bonds offer investors predictability when the stock market is an unpredictable investment. When investing in bonds from long-established and financially strong companies, there is little to worry about during a recession due to the strength of their position. The risks investors have to worry about are bonds that are issued by companies that are highly leveraged or speculative.
During a recession, many companies reduce their dividend rate. Many individuals may rely on dividend income to supplement a portion of their income and with a reduction in dividends, can find themselves in a difficult situation. The demographic that is impacted the most by declining dividend rates is typically the elderly who are retired. The alternative to dividend income is bond interest. The reason why this is an excellent substitute is that the interest rates on bonds do not change no matter the economic climate. The pre-agreed-upon interest rate will stay the same but dividend rates can be reduced.
Although investors don’t purchase bonds to sell at a later for returns, it is possible to make money when selling bonds. During a recession, many investors sell their shares in companies and opt to invest in bonds. As a result of the sudden influx of capital into the bond market, the prices of bonds increase, allowing bondholders to sell their bonds and make a profit.
In short, bonds are an excellent addition to a portfolio, especially when there is a recession. The reason why that is true is that they offer stability, predictability, and a source of income. It is important to note that every investment has its risks and bonds are no exception. In general, they are safer than stocks, but they are not to be invested in haphazardly, look for the highest-yielding bonds that are secured by strong governments, or countries for the best options. This recession could be very different from the ones in the past, we just don’t know how it’s going to go so be sure to do plenty of research. This post was written by financialquazar on Fiverr. He’s written several investment posts for us over the past year. For more on investing during a recession read 5 Year Investment Plan During a Recession. Subscribe for more business, sales, and investing posts. Have a lovely day.
