Recessions are when business activity slows down for a prolonged period of time. They are typically marked by two consecutive quarters of GDP decline. During recessions, investors often seek safer assets, such as bonds, to protect their portfolios. Let’s explore the potential benefits and risks of investing in bonds during a recession.
A bond is essentially a securitized loan issued by various borrowers, such as the federal government, state and local issuers, corporations, and home mortgage aggregators. Bonds are often considered safer assets because bondholders receive priority for repayment over shareholders. The federal government issues Treasury securities, which are considered the one of the safest bonds. Interest rates are determined by the market, with Treasuries set by an auction and other bond rates are spread from Treasuries. The spread is determined by additional risks, especially the issuer’s ability to repay.
The Appeal of Bonds in a Recession
During a recession, the Federal Reserve often lowers interest rates to stimulate the economy. When the Fed cuts rates, the yield on existing bonds becomes more attractive, as they offer higher fixed interest payments than newly issued bonds with lower interest rates. Therefore, the demand for existing bonds increases, causing their prices to rise. During a recession, investors can benefit from this effect by selling their bonds at a profit before they mature.
Risks of Investing in Bonds
While bonds are generally viewed as safe, there are risks involved, particularly during a recession. These risks include:
Credit risk: The possibility that a business issuing the bond may not survive the recession, leading bondholders to lose principal investment. If a company goes bankrupt and its assets are liquidated, the proceeds may not cover the debts.
Inflation risk: In some recessions, inflation can erode the value of a bond. Even if bondholders receive all interest and principal payments, their purchasing power may be reduced if inflation surpasses the bond’s interest rate.
Interest rate risk: Although less common during a recession, if interest rates rise, bond values decrease as new bonds issued at higher rates become more attractive.
Conclusion: Bonds are great (in theory)
Bonds can be great investments during a recession if all the pieces fall in place. Their relative stability, potential for price appreciation when the Fed cuts interest rates, and predictable income make them an appealing choice for investors looking to navigate uncertain economic times. However, it is crucial to remember that predicting the beginning and ending of recessions is not an exact science, and there are always inherent risks for any kind of investing. Generally, we prefer stocks most of the time, but bonds can help some investors ride out a rocky and uncertain economy.