Investors typically hold a mix of stocks and bonds, with the general intention that bonds will reduce portfolio volatility and improve returns. That’s because of their greater predictability in terms of both safety and return. Has it proven true in these recent weeks of incredible stock market volatility, and if not, is there an alternative to bonds or should you stay put?
There’s an argument on both sides of that question, and the answer is yet to be determined. So, let’s look at how bonds have performed since the stock market peaked in the middle of February. From there, let’s attempt to make some projections based on current developments in the bond world.
U.S. Treasuries a True Port in a Storm?
As has typically been the case with most bear markets in stocks, U.S. Treasury securities have provided portfolio stability during a time of turmoil. Considered the safest of all securities, they’re a natural safe-haven asset class in nearly every type of crisis.
Data from the U.S. Treasurys Daily Treasury Yield Curve Rates shows yields on all but the 20- and 30-year Treasury bonds have fallen below 1%. That includes the 10-year Treasury note, which is considered a benchmark for other interest rates, such as mortgage rates.
But what may be more significant is that the yield on the 10-year note was a full percentage point higher as recently as January 2, when it sat at 1.88%.
However, yields are rising in recent days as investors dump treasuries to raise cash. Notice from the screenshot above that the yield on the 10-year note hit a low of 0.54% on March 9, only to rise to 0.88% on March 12. That’s an increase of 34 basis points in a space of just three days and corresponding with a continued decline in stocks.
The situation has become severe enough that the Federal Reserve announced a plan to pump $1.5 trillion into the markets, largely to stabilize U.S. Treasuries.
But despite the disruptions of the past few days, U.S. Treasuries have largely fulfilled their status as the ultimate safe-haven investment. If you’re sitting in U.S. government securities, that’s a good place to be, and a position you’ll want to hold.
However, the situation is not as clear-cut with other types of bonds.
Investment-grade bonds are something of a mixed bag. As measured by the Bloomberg Barclays US Corporate Total Return Value Unhedged USD, corporate bonds have an impressive one-year return of 9.76% as of March 12.
But more recent performance has been problematic. The index topped out at 3,426 on March 6 but fell to 3,208 by March 12. That’s a decline of just over 6% in only six days.
Its an open question whether the longer-term trend of the one-year return will resume, or if the economic effects of the coronavirus and other factors will continue to weigh the sector down. At this point at least, there’s no way to know.
The situation with high-yield corporate bonds has been more volatile. The Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD has recorded a drop from 2,210 on February 20, to 1,991 on March 12. That represents a decline in high-yield bonds of 10% in a space of just three weeks.
The coronavirus is causing financial distress among companies that issue high-yield bonds. An economic slowdown will translate into a reduction in cash flow, increasing the likelihood of defaults on the securities.
But the coronavirus isn’t the only tsunami confronting high-yield bonds. With many high-yield bonds having been issued by companies in the oil industry--particularly in the shale oil sector--the 50% plunge in oil prices since the beginning of the year is taking its toll.
Clearly, high-yield bonds aren’t providing the kind of portfolio protection anywhere close to U.S. Treasuries. Though the decline in the index is only about half the drop in stock values, a double-digit fall is not what investors expect from a fixed income portfolio.
Is it Time to Bail Out of Bonds?
It’s times like these when it’s important to remember the inverse relationship between interest rates and bond prices. Simply put, when interest rates fall, bond prices rise. When interest rates rise, bond prices fall.
The trend of the past several weeks has been for rates to fall, at least on U.S. Treasuries, though even that course has reversed in recent days. Most investors expect interest rates to continue to fall due to the economic weakness caused by the coronavirus. But in unstable markets, trends don’t necessarily follow expectations.
A rise in interest rates will cause the value of longer-term securities--those of maturities greater than 10 years--to decline in price. That being the case, the strongest argument for bonds is in those of shorter terms. Bonds with maturities of five years or less are likely to provide the most stable returns, with the lowest risk of principal.
In the current volatile market environment, yield is less important than the preservation of capital. Shorter-term bonds, though they may provide lower yields, should provide that preservation of capital. That will be true of U.S. Treasuries and likely high-grade corporate bonds as well.
But as we’ve seen in recent weeks, the story will be far from certain with high-yield bonds. After all, there’s a good reason why they used to be called junk bonds. If current market conditions persist or worsen, that name may return.
Is There an Alternative to Bonds?
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If the core purpose of holding bonds is the preservation of capital, there are options that will provide complete safety of principal with guaranteed yield. In the financial environment were now in, bank deposit accounts can serve much the same purpose as bonds. And equally significant, they can provide the type of liquidity that may be necessary against the backdrop of the coronavirus.
But we’re not talking about the yields you can get at your local bank or credit union. According to the FDIC’s Weekly National Rates and Rate Caps Weekly Updates, the average yield on savings accounts is a paltry 0.06%, while the return on a one-year CD averages just 0.17%.
Savings accounts and CDs that pay such low-interest rates will certainly keep your money safe. But if you’re looking for higher yields, you can find them through high-yield online savings accounts. For example, the CIT Bank Savings Builder Account is currently paying .45% APY with a minimum opening balance of $100, and $100 minimum monthly deposits. It’s a way for even small investors to earn high interests, with complete safety of principal.
And CIT Bank is one of many online banks paying high yields on online savings accounts.
If you’re looking to lock in high rates for the longer term, you can also choose high-yield certificates of deposit (CDs). For example, Marcus by Goldman Sachs is currently paying 1.20% APY on a 12-month high-yield CD. You can open one with a deposit of just $500.
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Technically speaking, high-yield savings accounts and CDs are not bonds. But in the instability currently prevailing in the financial markets, they can serve much the same purpose. Not only will they protect a portion of your portfolio from market declines, but they’ll enable you to have cash available to buy stocks at bargain prices when the current downturn ends.
Related: Bonds vs. CDs