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In Case of Recession are Bonds Good at Shielding a Portfolio?

Nearly one third of all banking customers maintain less than $1000 in their account and a similar number have accounts at more than one financial provider.

Shifting economic headwinds are prompting investors to rethink their asset allocation, including fixed-income instruments. With inflation nipping at their heels, Americans are keen to get their idle cash working for them and producing increased returns. According to a March study by J.D. Power, the percentage of U.S. customers with $10,000 or more in primary bank deposit balances declined 16% over the past year.

Yet the successful moves from the past decade – to stick your cash into ETFs, mutual funds, or tech unicorns may not hold in this new environment. For risk-averse investors, fixed-income instruments like bonds may provide shelter amid rising economic uncertainty.

Back in Force?

Last year was one of the worst ever for bonds in decades. Indexes that track aggregate bond funds, such as Barclay’s U.S. Aggregate Bond Index, showed a decline of around 13%, the worst year since at least 1976.

“The Federal Reserve raised rates more than they have in 40 years. That caused massive losses for bondholders,” Robert Gilliland, managing director at Concenture Wealth Management, told CNBC earlier this year. “It’s important to understand that bonds are generally secure, but not necessarily safe.”

Yet could last year’s downturn set bonds up for a comeback? Conventional wisdom has held that bonds and equities are inversely correlated, with the price of one rising when the other falls.

A recent research report published by leading asset manager BlackRock asserts the former 60-40 equity-to-bond allocation is ill-suited in a period where “major central banks are hiking interest rates into recession to try to bring inflation down.”

Despite signs of an imminent Fed pivot, the stock market continues to crabwalk sideways. The benchmark S&P 500 index has hovered between 4,300 and 3,800 points since the start of the year, neither falling back into last year’s lows nor recovering the upward momentum to reach pandemic highs. This has hindered the returns of passive investors whose portfolios are allocated heavily toward index funds, such as popular ETFs such as iShares Core S&P 500 ETF (IVV) and SPDR Portfolio S&P 500 ETF (SPLG). The plateauing in the stock markets may warrant a closer look at the bond bull case.

Class of Their Own

Bonds may not be sexy as stocks, but they don’t diminish their value to investors in times of stress. They offer a unique value proposition, especially for those seeking stability. They function as IOUs issued by governments or companies that promise to pay back the original investment plus interest over a set period of time.

This can make them a practical asset to buttress a portfolio and offset volatility during the economic turmoil of a recession. They can also offer a form of passive income, paying out regular coupons, with a lower risk profile that favors a more conservative investing approach.

There are two sides to the bond equation during the current high-inflation, high-interest environment. Although monetary tightening hurt those last year who already had an extensive bond portfolio when interest rates rose, as the Fed looks closer to dampening inflation, some may argue the setup for a rebound in bond prices may be just around the corner.

For new buyers, this moment pay present a chance to buy bonds at a discount, and even if interest rates are not lowered immediately, market yields are already offering significantly generous rates at 4% or higher.

Junk or Official?

While most mainstream media focus on the government-issued type of bonds, it is crucial not to lose sight of corporate bonds.

These bonds are issued by private firms, and as such, their debt is less iron-clad than the guarantee of a government to repay its debts. For this reason, they are considered riskier and depend on the creditworthiness of the company. 

The lowest credit-rated firms are often referred to as “junk” bonds. Yet that added risk can pay off. Corporations typically pay higher yields to investors for taking on their bonds.

Whether or not higher compensation makes sense depends on an investor’s outlook and risk appetite. Some defensive investors may nonetheless prefer the safety of Treasury Bonds.

“If you’re concerned about the possibility of a recession, these current valuations in investment-grade credits aren’t very appealing,” Alfonzo Bruno, associate portfolio manager at Morningstar Investment Management, commented earlier this year. “I would rather hang out in safer fixed income where I can still get paid a decent yield,” he added.

When leveraged correctly, bonds can deliver value to a portfolio. During instability, they offer a safe middle ground between the volatility of the stock market and the dwindling value of an idle cash pile. Approached the right way, they may prove valuable as a good investment option to tide over times of turmoil. Yet bond buyers should pay careful attention to Fed policy, as an imminent Fed pivot could alter the buy case for the asset.

Josh Dudick

Josh is a financial expert with over 15 years of experience on Wall Street as a senior market strategist and trader. His career has spanned from working on the New York Stock Exchange floor to investment management and portfolio trading at Citibank, Chicago Trading Company, and Flow Traders.

Josh graduated from Cornell University with a degree from the Dyson School of Applied Economics & Management at the SC Johnson College of Business. He has held multiple professional licenses during his career, including FINRA Series 3, 7, 24, 55, Nasdaq OMX, Xetra & Eurex (German), and SIX (Swiss) trading licenses. Josh served as a senior trader and strategist, business partner, and head of futures in his former roles on Wall Street.

Josh's work and authoritative advice have appeared in major publications like Nasdaq, Forbes, The Sun, Yahoo! Finance, CBS News, Fortune, The Street, MSN Money, and Go Banking Rates. Josh currently holds areas of expertise in investing, wealth management, capital markets, taxes, real estate, cryptocurrencies, and personal finance.

Josh currently runs a wealth management business and investment firm. Additionally, he is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses professionally.