Key points
- A recession is a decline in economic activity over several months.
- Bonds are debt securities that companies and governments use to borrow money from investors.
- Bonds have many benefits during a recession, but they also carry risks.
If you’ve been listening to the news lately, you’re probably at least a little concerned about a recession on the horizon. You may also be wondering what to invest in to protect your money.
Bonds are an asset you may hear financial experts emphasize. Yes, some bonds are safe during a recession. Others, not so much.
Bonds, which are essentially loans made by investors to businesses and governments, provide a steady cash flow and reduce the risk of losing your initial investment. But are they really safe during a recession? We spoke with two investment experts to find out.
The short answer is that bonds tend to be less volatile than stocks and often perform better than other financial assets during recessions. However, they also carry their own set of risks, including default risk and interest rate risk.
What is a recession?
A recession is a period of economic decline and a normal part of the business cycle. According to the National Bureau of Economic Research, the organization that declares whether we are in a recession, it is “a significant decline in economic activity that spreads throughout the economy and lasts for more than some months “.
Kelly Kowalski, a chartered financial analyst and portfolio manager at MassMutual, says there are different schools of thought on what a recession means.
“A recession can be defined as two consecutive quarters of economic contraction, but this is not a hard and fast rule,” says Kowalski.
During recessions, we will likely see a decline in gross domestic product (the value of goods and services produced domestically), increased unemployment, and a reduction in business activity, including production and sales. .
Recessions are certainly no fun, but they are a normal part of the business cycle. Most investors will experience more than one recession in their lifetime and will feel the impact on their portfolios.
What are bonds?
Think of a bond as a loan. It is a security (a financial asset) issued by a company or government entity to raise funds. The investor lends a certain amount of money to the bond issuer. The bond issuer pays interest to the investor over the life of the bond and repays the face value of the bond when it matures.
Bonds come in many different forms which can generally be divided into three categories.
1. Corporate bonds
Corporate bonds are issued by public and private companies. Interest rates on corporate bonds are affected by the creditworthiness of the issuing company, meaning a blue-chip company may pay less.
In contrast, a high-yield bond – also known as a junk bond – can yield more. But because it’s issued by a company with a lower credit rating, the risk of them not paying is higher.
2. Municipal Bonds
Municipal bonds are issued by states, cities and counties and can be broken down further:
- General Obligation Bonds. These bonds are unsecured debts that government entities use for a variety of purposes. They are generally reimbursed with tax money collected by the entities.
- Tax obligations. These links can be used to finance particular projects and are generally repaid using the revenue generated by those projects. If the project does not generate the expected revenue, this could result in default.
- Duct connections. These bonds are issued by municipalities on behalf of private entities such as hospitals or universities. In this case, the borrower leads, that is to say the organization on whose behalf the bonds were issued, must reimburse the municipality. If it does not do so, the municipality may not be able to repay the bonds.
3. Treasury Securities
Treasury securities are issued on behalf of the U.S. Department of the Treasury. They are backed by the full faith and credit of the U.S. government, making them the safest of all bond types. Treasury securities fall into several different categories, depending on the duration and nature of the obligation.
An example is the I bond, which pays a rate linked to inflation. With inflation raging in 2022, the I bond has attracted a lot of attention from investors seeking refuge from the decline in the stock market. Although the rate has since fallen – 4.28% through October 2024, compared to 9.62% for a period in 2022 – the I bond can still be a good hedge against inflation in the long term.
Guide to Treasury Bills: How and when to buy
Are bonds a safe investment during a recession?
Many people view bonds as a safe alternative to stocks. Since recessions are often accompanied by stock market declines, it makes sense for investors to turn to bonds.
While it’s true that bonds are less volatile and tend to outperform stocks during recessions, that doesn’t necessarily make them a safe investment or mean you should only invest in bonds during recessions.
As we mentioned above, there are many types of bonds. And while some – notably U.S. Treasury securities – are virtually risk-free, others carry risk.
The decision to invest in bonds depends less on the state of the economy and more on your investment goals, says Robert Johnson, professor of finance at Creighton University’s Heider College of Business. He recommends creating an investment policy statement, or IPS, in which you define investment objectives and an investment strategy.
“The purpose of an IPS is to guide you through changing market conditions,” says Johnson. “This should not be changed due to economic or market fluctuations. It should only be revised when your personal circumstances change.
Why might bonds be a safe investment?
Bonds’ reputation as safer investments is not entirely unjustified. They have advantages that investors may find particularly attractive during recessions.
Bonds tend to be less volatile and generally outperform stocks during recessions.
A bond is essentially a loan. The recovery of your investment depends on the issuing entity repaying this loan.
“Bonds, such as Treasuries, corporate bonds, and municipal bonds, have contractual cash flows,” Kowalski explains. “Compared to stocks, the likelihood of losing your initial investment is much lower because the bond issuer agrees to repay interest and principal on specific dates.”
Default risks are even lower when it comes to investment grade bonds or bonds issued by the federal government.
Bonds provide a regular source of income
Many long-term bonds pay interest to investors every six months. At a time when your stock investments may lose value and dividends may fall, this interest income can be particularly attractive.
Risks
While bonds have benefits, they also have risks to consider.
Bonds don’t completely eliminate the risk of losing your money
A bond is a loan, and bond issuers can default on their loans just like any other borrower.
“Investors in corporate bonds, particularly junk bonds, should be concerned about default risk,” Johnson says. “And when the economy enters a recession, the likelihood of business failure increases. »
Rising Interest Rates Are Bad News for Existing Bond Holders
As a bond investor, it’s easy to view rising interest rates as a positive. But this is only the case for people who are considering investing in bonds, not for those who have already done so.
“For existing bondholders, rising interest rates are bad news,” Johnson says. “As rates rise, the value of bonds already issued declines. »
Bonds May Have Lower Yields Than Stocks
You may be able to protect some of your money by investing in bonds during a recession. But the stock market tends to be forward-looking, meaning it will likely begin to rebound before the recession ends. When this happens, you run the risk of having your money tied up in bonds rather than taking advantage of the potential growth of the stock market.
This doesn’t mean you shouldn’t invest in bonds at all during a recession. But it supports Johnson’s point that your investment strategy shouldn’t necessarily change depending on whether or not the economy is in recession.
Frequently Asked Questions (FAQ)
Yes, you can lose money investing in bonds if the bond issuer defaults on the loan or if you sell the bond for less than you bought it for.
Even if the stock market crashes, your bond investments are unlikely to be hit hard. However, companies that were hit hard by the crash may struggle to repay their obligations.
There are many types of bonds, so rather than looking for an alternative to bonds, it may make more sense to choose the bond that best suits your investment goals.
