14

I believe that another crisis is imminent if Trump goes ahead with deregulation of financial firms. Whether that is true or not is not my actual question. In that context, I want to protect my 401K money to the maximum extent possible.

My layman thought is that I can invest my money in bonds and not stocks to reduce the risk at the cost of not making big returns. My question is whether that is a fair statement? Can bonds lose money in any case?

My current Fidelity plan offers only one "bond investments fund" — MetWest Total Return Bond Fund which didn't exist during 2008 for me to see how it fared.

I see sometimes that the NAV for this bonds based fund going down yielding a net negative growth for a day or month. How does this work during a crisis?

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    The fund you list is down 2.64% in the last 3 months while stocks have gone straight up. What does that tell you? Who told you "bonds are recession proof"? – JoeTaxpayer Feb 4 '17 at 2:22
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    If the company goes under, their bonds immediately become wastepaper. – MMacD Feb 4 '17 at 19:25
  • @JoeTaxpayer , Yes, this is the only bonds based fund available to me in my 401K account, and it is down recently, hence my questions. I assumed that bonds would be low yield, and low risk, but didn't quite understand how they work in a "crisis" scenario. Intuitively, I was thinking bonds meant "I'll pay you xyzzy no matter what, but not more of any market upsides". It appears that they aren't that simple..... – Aravindh Sathish Feb 4 '17 at 20:48
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    @AravindhSathish If you really only want preservation of wealth after inflation, then you may be interested in TIPS. treasurydirect.gov/indiv/products/prod_tips_glance.htm If you are worried that TIPS will not be honored, then you are actually concerned about the breakdown of the entire US economy, and you should probably invest in land, fruit and nut trees, firearms, etc... – Steven Gubkin Feb 4 '17 at 21:23
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    You shouldn't be trying time time the market with your 401K money. You should have a market-timing independent strategy and stick with it for the long-term. For a retirement portfolio, some of your assets should already be in a broadly diversified bond fund, but you shouldn't be changing your asset allocation based on what you see on the news. – DavidS Feb 4 '17 at 22:59
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No, they are not recession proof.

Assume several companies, that issued bonds in the fund, go bankrupt. Those bonds could be worthless, they could miss principle payments, or they could be restructured. All would mean a decline in value.

When the economy shrinks (which is what a recession is) how does the Fed respond? By lowering interest rates. This makes current bonds more valuable as presumably they were issued at a higher rate, thus the recession proof prejudice.

However, there is nothing to stop a company (in good financial shape) from issuing more bonds to pay the par value on high-interest bonds, thus refinancing their debt. Sort of like how the bank feels when one refinances the mortgage for a lower rate.

The thing that troubles me the most is that rates have been low for a long time. What happens if we have a recession now? How does the Fed fix it? I am not sure exactly what the fallout would be, but it could be significant.

If you are troubled, you should look for sectors that would be hurt and helped by a Trump-induced recession. Move money away from those that will be hurt. Typically aggressive growth companies are hurt (during recessions), so you may want to move money away from them. Typically established blue chip companies fare okay in a recession so you may want to move money toward them. Move some money to cash, and perhaps some towards bonds.

All that being said, I'd keep some money in things like aggressive growth in case you are wrong.

  • How does the Fed fix it? Rates can go negative. Its rare but has happened in a couple of central banks. That being said, its still going to hurt. – David Grinberg Feb 4 '17 at 0:16
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    Not all bonds can be paid off early, only those designated at issue as 'callable' and usually only at prespecified times, and they normally have a higher coupon to compensate for the upside limitation. – dave_thompson_085 Feb 4 '17 at 3:25
  • @Pete B. , so companies could go bankrupt and the bonds they issues could hurt overall funds value. The fund I listed only gives me a breakdown by category, and I practically have no say in where my money gets invested in then. Your tip about picking some sectors that may not be affected by a crisis too much isn't an option in my 401K walled garden though. I could do that with my cash, but not with the small list of funds that my 401K provides gives me. So, there is no escaping of market risk with 401K? – Aravindh Sathish Feb 4 '17 at 20:59
  • Are municipal bonds any different? Or does this cover them too? – Bobson Feb 5 '17 at 1:19
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    Also, on the practical side, the reason Treasury Bonds are considered stable is because the US Gov't has always honored them and has not defaulted on them. The Current US President has been bankrupted multiple times, and has suggested simply not paying the country's debts. While I doubt it will change, US Treasury Bonds could become worthless. – Marshall Tigerus Feb 6 '17 at 15:00
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Bonds by themselves aren't recession proof. No investment is, and when a major crash (c.f. 2008) occurs, all investments will be to some extent at risk. However, bonds add a level of diversification to your investment portfolio that can make it much more stable even during downturns.

Bonds do not move identically to the stock market, and so many times investing in bonds will be more profitable when the stock market is slumping. Investing some of your investment funds in bonds is safer, because that diversification allows you to have some earnings from that portion of your investment when the market is going down.

It also allows you to do something called rebalancing. This is when you have target allocation proportions for your portfolio; say 60% stock 40% bond. Then, periodically look at your actual portfolio proportions. Say the market is way up - then your actual proportions might be 70% stock 30% bond. You sell 10 percentage points of stocks, and buy 10 percentage points of bonds. This over time will be a successful strategy, because it tends to buy low and sell high.


In addition to the value of diversification, some bonds will tend to be more stable (but earn less), in particular blue chip corporate bonds and government bonds from stable countries. If you're willing to only earn a few percent annually on a portion of your portfolio, that part will likely not fall much during downturns - and in fact may grow as money flees to safer investments - which in turn is good for you. If you're particularly worried about your portfolio's value in the short term, such as if you're looking at retiring soon, a decent proportion should be in this kind of safer bond to ensure it doesn't lose too much value.

But of course this will slow your earnings, so if you're still far from retirement, you're better off leaving things in growth stocks and accepting the risk; odds are no matter who's in charge, there will be another crash or two of some size before you retire if you're in your 30s now. But when it's not crashing, the market earns you a pretty good return, and so it's worth the risk.

7

Without providing direct investment advice, I can tell you that bond most assuredly are not recession-proof. All investments have risk, and each recession will impact asset-classes slightly differently.

Before getting started, BONDS are LOANS. You are loaning money. Don't ever think of them as anything but that.

Bonds/Loans have two chief risks: default risk and inflation risk.

Default risk is the most obvious risk. This is when the person to whom you are loaning, does not pay back. In a recession, this can easily happen if the debtor is a company, and the company goes bankrupt in the recessionary environment.

Inflation risk is a more subtle risk, and occurs when the (fixed) interest rate on your loan yields less than the inflation rate. This causes the 'real' value of your investment to depreciate over time.

The second risk is most pronounced when the bonds that you own are government bonds, and the recession causes the government to be unable to pay back its debts. In these circumstances, the government may print more money to pay back its creditors, generating inflation.

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    Thanks for the response. Looking at them as aggregated loans makes more sense and gave perspective to me. If it is loaned to trustworthy parties such as US Treasury, they may be low risk or safer vs mortgage backed bonds which can become something 2008. But, abstractly, bonds can only help diversify investment portfolio and NOT necessarily avert risks completely. – Aravindh Sathish Feb 5 '17 at 3:51
  • There is a third risk, that interest rates will go up and the value of the bond will fall. If you hold individual bonds to maturity, you avoid that risk. But if you hold bond funds, or if you sell individual bond to another investor before it matures, there can be a loss of principal. – stannius Feb 8 '17 at 22:20
3

You're mixing up two different concepts: low-risk and recession-proof.

I'll assume I don't need to explain risk: there is always risk, regardless what form you keep your assets in.

With bonds, the interest rate is supposed to reflect the risk. If a company offers bonds with too low an interest rate for the risk level, few people will buy them. While if a company offers bonds with too high an interest rate for the level of risk, they are gypping themselves. So a bond is a slightly more transparent investment from a risk assessment perspective, but that doesn't mean the risk is necessarily low: if you buy a bond with a 20% effective annual yield, that means there is quite a high risk that the underlying company will fold (unless inflation is in the double-digit range as well, in which case a 20% yield is not that much).

Whereas with a stock, no parameter directly tells you anything about the risk.

Recession-proof is not the same thing as low-risk. Recession-proof refers to investing in (or holding debt for) industries that perform better in a recession. http://www.investopedia.com/articles/stocks/08/industries-thrive-on-recession.asp.

3

That depends on how you're investing in them.

Trading bonds is (arguably) riskier than trading stocks (because it has a lot of the same risks associated with stocks plus interest rate and inflation risk). That's true whether it's a recession or not.

Holding bonds to maturity may or may not be recession-proof (or, perhaps more accurately, "low risk" as argued by @DepressedDaniel), depending on what kind of bonds they are. If you own bonds in stable governments (e.g. U.S. or German bonds or bonds in certain states or municipalities) or highly stable corporations, there's a very low risk of default even in a recession. (You didn't see companies like Microsoft, Google, or Apple going under during the 2008 crash).

That's absolutely not the case for all kinds of bonds, though, especially if you're concerned about systemic risk. Just because a bond looks risk-free doesn't mean that it actually is - look how many AAA-rated securities went under during the 2008 recession. And many companies (CIT, Lehman Brothers) went bankrupt outright.

To assess your exposure to risk, you have to look at a lot of factors, such as the credit-worthiness of the business, how "recession-proof" their product is, what kind of security or insurance you're being offered, etc.

You can't even assume that bond insurance is an absolute guarantee against systemic risk - that's what got AIG into trouble, in fact. They were writing Credit Default Swaps (CDS), which are analogous to insurance on loans - basically, the seller of the CDS "insures" the debt (promises some kind of payment if a particular borrower defaults). When the entire credit market seized up, people naturally started asking AIG to make good on their agreement and compensate them for the loans that went bad; unfortunately, AIG didn't have the money and couldn't borrow it themselves (hence the government bailout).

To address the whole issue of a company going bankrupt: it's not necessarily the case that your bonds would be completely worthless (so I disagree with the people who implied that this would be the case). They'd probably be worth a lot less than you paid for them originally, though (possibly as bad as pennies on the dollar depending on how much under water the company was). Also, depending on how long it takes to work out a deal that everyone could agree to, my understanding is that it could take a long time before you see any of your money.

I think it's also possible that you'll get some of the money as equity (rather than cash) - in fact, that's how the U.S. government ended up owning a lot of Chrysler (they were Chrysler's largest lender when they went bankrupt, so the government ended up getting a lot of equity in the business as part of the settlement).

Incidentally, there is a market for securities in bankrupt companies for people that don't have time to wait for the bankruptcy settlement. Naturally, people who buy securities that are in that much trouble generally expect a steep discount.

To summarize:

  • Trading bonds is (arguably) risky compared to trading stocks
  • Holding certain kinds of high-quality bonds to maturity is low-risk even in a recession. The key word is "certain kinds" - just because a bond looks low-risk doesn't mean that it actually is once you account for systemic risk.
  • Even in the event of a bankruptcy, that doesn't necessarily mean that all is lost. If the debt was secured or insured you may get money back, and you could get money back even in a bankruptcy (either by getting a settlement in bankruptcy court or selling it to a distressed debt fund at a discount).
2

During the hyperinflation of the Wiermer republic, corporate stocks and convertible bonds were thought second only to the species (gold, silver etc) as the only secure currencies.

As Milton Friedman proved, inflation is caused solely by the monetary token supply increasing faster than productivity. In the past, days of species of currency, it was caused by governments debasing the currency e.g. streatching the same amount of silver in 50 coins to 100 coins. Sudden increases in the supply of precious metals can also trigger it. The various gold rushes in 19th century and later, improvements in extraction methods caused bouts of inflation. Most famously, the huge amounts of silver the Spanish extracted from the New World mines, devastated the European economy with high inflation.

Governments use inflation as a form of stealth flat tax. Money functions as an Abstract Universal Trade Good and it obeys all the rules of supply and demand. If the supply of money goes up suddenly, then its value drops in relation to real goods and service. But that drop in value doesn't occur instantly, the increased quality of tokens has to percolate through the market before the value changes.

So, the first institution to spend the infalted/debased currency can get the full current value from trade. The second gets slightly less, the third even less and so on. In 2008, the Federal reserve began printing money and loaning at 0% to insolvent backs who then used that money to buy T-Bill. This had the duel effect of giving the banks an (arbitrary) A1 rated asset for their fractional reserve while the Federal government got full pre-inflation value of the money paid for the T-bills. As the government spent that money, the number of tokens increased fast than the economy.

In times of inflation, the value of money per unit drops as its supply increases and increases The best hedges against inflation are real assets e.g. land, equipment, stocks (ownership of real assets) and convertible bonds which are convertible to stock.

It's important to remember that money is, of itself, worthless. It's just a technology that abstracts and smilies trading which at the base, is still a barter system. During inflation the barter value of money plunges owing to increased supply. But the direct barter value between any two real assets remain the same because their supplies have not changed.

The value of stocks and convertible bonds is maintained by the economic activity of the company whose ownership they represent. Dividends, stock prices and bond equity, as measured in the inflated currency continue to rise in sync with inflation. Thus they preserve the original value of the money paid for them.

Not sure why you expect more inflation. The only institution that can create inflation in the US is the Federal Reserve which Trump has no direct control off. Deregulation of banks won't cause inflation in and of itself as the private banks cannot alter the money supply. If banks fail, owing to deregulation, unlikely I think given the dismal nearly century long record of regulation to date, then the Federal Reserve might fix the problem with another inflation tax, but otherwise not.

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    "The only institution that can create inflation in the US is the Federal Reserve" Not true. The other 97% of the world population can also create inflation for the USA simply by selling dollars. Even worse, the rest of the world can sell dollars that it doesn't actually have, in the expectation it can buy them back cheaper in future. And hey, don't call in the financial regulators, Trump just fired them.... and you can't outrun the currency markets in the medium term (say 2-3 years) by chanting a "made in the USA" slogan. – alephzero Feb 4 '17 at 8:17
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    @alephzero9: There are no historical examples of inflation of large fiat currency caused by currency exchanges or by secondary markets. Merely selling dollars does not create inflation because for every seller, there is a buyer. They have to exchange them for something.Beside the US comprises at least 25% of planetary GNP. So it’s a huge system. hard for private actors to effect. The number of monetary tokens vs the productivity of the US remains the same. Given that circa 1980 the Fed stopped 6 years of double digit inflation with the flip of a switch, clearly the Fed is controlling factor. – TechZen Feb 4 '17 at 17:33
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    @alephzero9: I no longer bother to follow the news but if Trump fired a bunch of financial regulators... good. Given that these self same regulators raised no warnings about the any recent financial implosions and in 2007 were certify banks as rock solid right up until the very day they imploded, they should be fired. Financial regulation is an illusion, political pixe dust. The banking systems has grown far to complex and has to much random political noise crammed in it e.g. declaring Freddie and Fanny bonds as A1 like T-bils for banks fractional reserve, thus creating a loop of IOUs. – TechZen Feb 4 '17 at 17:40
  • Actually, private banks can and do modify the money supply. discusseconomics.com/banking/where-do-banks-get-their-money – EJoshuaS Feb 9 '17 at 8:03
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Yes. Bonds perform very well in a recession. In fact the safer the bond, the better it would do in a recession.

Think of markets having four seasons:

  • High growth and low inflation - "growing economy"

  • High growth and high inflation - "overheating economy"

  • Low growth and high inflation - "stagflation"

  • Low growth and low inflation - "recession"

Bonds are the best investment in a recession. qplum's flagship strategy had a very high allocation to bonds in the financial crisis. That's why in backtest it shows much better returns.

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