Key points
- A recession is a decline in economic activity over many months.
- Bonds are debt securities companies and governments use to borrow money from investors.
- Bonds have many advantages during a recession, but they also have risks.
If you’ve tuned in to the news lately, you’re probably at least a bit concerned about a recession on the horizon. You may also be wondering what you can invest in to keep your money safe.
One asset you may hear financial experts point to is bonds. Yes, some bonds are safe during recessions. Others, not so much.
Bonds, which are basically loans from investors to corporations and governments, provide regular cash flow and a decreased chance 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 bonds tend to be less volatile than stocks and often perform better during recessions than other financial assets. However, they also come with 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’re in a recession, it’s “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”
Kelly Kowalski, a chartered financial analyst and portfolio manager at MassMutual, says there are different schools of thought when it comes to what signifies a recession.
“A recession can be defined as two sequential quarters of economic contraction, but it is not a hard-and-fast rule,” Kowalski says.
During recessions, we are likely to see declines in gross domestic product (the value of goods and services produced in the country), increases in unemployment and reductions in business activity, including production and sales.
Recessions certainly aren’t fun, but they are a normal part of the business cycle. Most investors will live through more than one recession in their lifetimes and feel the impact on their portfolios.
What are bonds?
Think of a bond like a loan. It’s a security (a financial asset) issued by a corporation or government entity as a way of raising money. The investor lends the bond issuer a certain amount of money. The bond issuer makes interest payment to the investor during the bond term and repays the face value of the bond when it matures.
Bonds come in many different forms that can generally be broken into three categories.
1. Corporate bonds
Corporate bonds are issued by public and private corporations. Interest rates on corporate bonds are affected by the creditworthiness of the issuing company, meaning a top-notch company may pay less.
On the other hand, a high-yield bond — also known as a junk bond — may pay more. But because it’s issued by a company with a lower credit rating, there’s a higher risk it won’t pay.
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 debt government entities use for a variety of purposes. They are usually paid back with tax dollars the entities collect.
- Revenue bonds. These bonds can be used to finance particular projects and are typically paid back using the revenue generated by those projects. If the project doesn’t generate the expected revenue, it could result in default.
- Conduit bonds. These bonds are issued by municipalities on behalf of private entities like hospitals or universities. In this case, the conduit borrower, meaning the organization on whose behalf the bonds were issued, must pay back the municipality. If it fails to 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. Treasury Department. 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 a few different categories, depending on the term and nature of the bond.
One example is the I bond, which pays a rate that is linked to inflation. With inflation raging in 2022, the I bond garnered much attention from investors seeking refuge from the flagging stock market. While the rate has decreased since then — 6.89% through April compared to 9.62% for a time last year — the I bond may still be a good long-term inflation hedge.
Treasury bonds guide: How and when to buy
Are bonds a safe investment during a recession?
Many people consider bonds to be safe alternatives to stocks. Considering recessions are often accompanied by stock market declines, it makes sense investors would turn to bonds.
While it’s true bonds are less volatile and tend to outperform stocks during a recession, that doesn’t necessarily make them safe investments or mean you should invest strictly in bonds during a recession.
As we mentioned above, there are many types of bonds. And while some — namely U.S. Treasury securities — are practically risk-free, others carry risks.
Whether you should invest in bonds depends less on the state of the economy and more on your investment goals, says Robert Johnson, a professor of finance at the Heider College of Business at Creighton University. He recommends creating an investment policy statement, or IPS, where you set investment objectives and an investment strategy.
“The whole point of an IPS is to guide you through changing market conditions,” Johnson says. “It should not be changed as a result of economic or market fluctuations. It only needs to be revised when your individual circ*mstances change.”
Why might bonds be a safe investment?
Bonds’ reputation as safer investments isn’t entirely unwarranted. They have benefits investors may find especially attractive during a recession.
Bonds tend to be less volatile and generally outperform stocks during a recession
A bond is essentially a loan. Whether you get your investment back depends on the issuing entity repaying that loan.
“Bonds, such as Treasurys, corporate bonds and municipal bonds, have contractual cash flows,” Kowalski says. “Compared to stocks, there is a much lower likelihood of losing your initial investment because the issuer of the bond agrees to pay interest and principal back at specific dates.”
The chances of default are even lower when you’re talking about investment-grade bonds or bonds issued by the federal government.
Bonds provide a regular source of income
Many long-term bonds make interest payments to investors every six months. At a time when your stock investments may be losing value and dividends may be falling, that interest income can be especially attractive.
Risks
While bonds have advantages, there are also risks to consider.
Bonds don’t completely eliminate the chances of losing your money
A bond is a loan, and bond issuers can default on their loans just like any other borrower can.
“Investors in corporate bonds, particularly junk bonds, should be concerned with default risk,” Johnson says. “And when the economy enters a recession, the likelihood of corporate defaults rises.”
Rising interest rates are bad news for existing bondholders
As a bond investor, it’s easy to see rising interest rates as a benefit. But that’s the case only for people who are considering investing in bonds, not those who already have.
“For existing bondholders, rising interest rates are bad news,” Johnson says. “As rates rise, the value of already-issued bonds falls.”
Bonds may have lower returns 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 start rebounding before the recession ends. When that happens, you run the risk of having your money tied up in bonds rather than taking advantage of potential stock market growth.
That’s not to say that you shouldn’t invest in bonds at all during a recession. But it does support Johnson’s point that your investment strategy shouldn’t necessarily change based on whether the economy is in a recession.
Frequently asked questions (FAQs)
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, you aren’t likely to see your bond investments take large hits. However, businesses that have been hard hit by the crash may have a difficult time repaying their bonds.
There are many bond types, so rather than looking for an alternative to bonds, it might make more sense to choose the bond that best fits your investment goals.
