Financial Options

The latest reader question, «What happens to bonds in a recession?» is a great one, because it addresses the fact that recession's effects on bonds aren't limited to the most direct effect. The knee jerk answer, had the reader asked «What happens to bond prices in a recession?» would have been «They increase.» But there's more to the story than that.

Still, a good place to start is looking at why bond prices would tend to increase during a recession. If we're speaking about long term US Treasury Bonds or the very highest investment grade bonds, we would expect their prices to increase during a recession. Why? Because interest rates tend to fall during a recession. When bond prices fall, interest rates rise and vice versa.

But there is more to the story, when it comes to bonds and recessions. With less than investment grade bonds, recession increases the default risk - the possibility that the company won't pay the bonds as agreed. If the risk of default increases, investors will demand a higher return. Higher return means lower price. While it's not likely that a recession would raise default risks enough generally to override the interest effect for the bond market as a whole, especially for those investment grade bonds, there is another factor at play - bond ratings. Recession or any sort of turmoil tends to mean that some corporations will see their credit ratings downgraded. When the rating agencies downgrade a company's bonds, the yields investors demand on those bonds rise and prices fall. So, while your particular bond might be expected to rise because of the interest rate effect, you can get sucker punched by a downgrade. So, with bonds as much as with stocks diversification and research are both important.

Another effect, that reinforces the interest rate effect, is that large institutional investors tend to allocate more of their portfolios to debt securities (including bonds) during softer economic growth and more to equity securities (stocks) during better economic times. (This is the basis for the State Street Investor Confidence Index). So, as the risk of recession rises, money moves out of stocks and into bonds, pushing up bond prices. As a recession matures and moves toward recovery, money should move the other way. This is one reason following the State Street Index is so important for the small investor. It would be ideal to beat the big guys to the punch and move your money first, but an awareness of the trend at least allows the small investor not to lag too badly.

Finally, it is important to note that the stage of the recession matters. Heading into a recession it's typical to see an inverted yield curve, where longer term interest rates are actually lower than short term rates. During an economic expansion or recovery, the yield curve normally rises; that is, longer term debt has higher interest rates than shorter term. Much of this is attributed to the lower risk of inflation heading into a recession. The further into a recession, the more the yield curve should sort itself out and the more long term interest rates will be pushed up, and bond prices down, by a rising risk of inflation.

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