During the heart of the late March 2020 market meltdown, I remember reading a lot of commentary about the problems in the bond markets. Poor performance, a lack of liquidity, potential of rising defaults etc. etc. It was like a highlight reel from the 2007 – 2009 Great Recession. Déjà Vu all over again.
The fact is – in both crisis – bonds behaved exactly as they should. The problem is that few investors understand how to use them properly and end up in trouble. Some concepts to keep in mind:
- First, the bond market is very broad but not very deep. You’ll have trouble finding a good buyer during any crisis. This is especially important for every sector other than plain vanilla Treasuries. The more complex the bond, the more liquidity (or the lack thereof) will be an issue.
- Corporate bonds have other problems. The big one is that they are linked to the stock market. When a company’s stock is under-pressure, what do you think is happening to its bonds? Also, under-pressure. So, if you thought an allocation to corporate bonds was a diversifier for your stock portfolio……you now know it is not! Do not expect anything different in the next crisis. Did you see what happened to bonds in 2007 – 2009? The current panic is just a re-run.
- Asset-backed bonds, mortgaged-backed, commercial mortgage-backed bonds, derivatives……..the list of exotic bonds goes on and on. Beware. They all look good when the economy looks good, but they all get very scary when the economy goes through periods of uncertainty. (Like now.)
So why do people buy inappropriate Bonds? Couple of reasons:
#1 Investors fall in love with the bond’s yield. When times are good, someone will show you a bond with a higher yield and say you should switch. You need to remember that the new bond is also a riskier security, and that extra riskiness likes to hide until a crisis breaks out. Extra yield always comes with extra risk.
#2 You get sold an inappropriate product. Financial Advisors often confuse Individual investors with Institutional investors. Individual Investors have different requirements and need products designed specifically for them. Do not feel “honored” to be able to purchase an Institutional Bond Fund. Very likely it is not what you want.
The Bottom Line:
If your Bond allocation is keeping you up at night, it is probably due to decisions you made a while ago. The Bond markets themselves are behaving as they should. The extra risks buried inside certain securities are now in full view, and their prices are falling – as they should.
The Bond market may rebound, or maybe only certain sectors will. We do not know what the future holds. In Part II of this blog, we’ll discuss appropriate goals for a bond allocation and how to satisfy these goals without getting tangled up in marketing hype or hidden risks.
This is being provided for informational purposes only, and should not be construed as a recommendation to buy or sell any specific securities. The views expressed are those of Southern Investment Management Collective (SIMC) and do not necessarily reflect the views of Mutual Advisors, LLC or any of its affiliates. SIMC, nor any of its members, are tax accountants or legal attorneys, and do not provide tax or legal advice. For tax or legal advice, you should consult your tax or legal professional. Investment advisory services offered through Mutual Advisors, LLC DBA Southern Investment Management Collective, a SEC registered investment adviser.
About the Author: Kent Fisher, CFA, CFP®
Kent Fisher is a Chapel Hill, NC Fee-Only Comprehensive Wealth Manager at the Southern Investment Management Collective (SIMC). SIMC provides comprehensive financial planning, retirement planning and investment management services to help clients organize, grow and protect their assets. SIMC serves clients as a fiduciary, and tailors all solutions to each client's unique situation.