Are Bonds the Answer to Coming Deflation?

Includes: BND, JNK, TBT, TLT
by: Nikhil Raheja

It is often mentioned that bonds outperform stocks during bear markets, while stocks outperform bonds during bull markets. While there is no denying the above, this statement may mislead some into assuming that Bonds are a good investment during recessions. Bonds did do much better than stocks in 2008; however they too fell victim to the negative sentiment and fell across the board. Bonds are only relatively better than stocks but are much worse than other safer investments like US Treasuries, other non-market based safe businesses, or cash.

Are bonds a good investment?

Bond and stock prices are based on interest rates and the future expected profits. Also, interest rates/yields have an inverse relationship with bond and stock prices, so as yields rise during a recession, prices for stocks and bonds fall. In addition, prices for stocks fall more since the expected profits from shareholding fall significantly due to pessimism, while the interest payments/coupons paid out on the Bonds remain the same.

So, we do acknowledge that bonds are better to hold than are stocks during the current crisis. However, it would be advisable to completely avoid both stocks and bonds, and instead buy investments that grow in value over such a crisis.

To gain a historical perspective on how bonds perform in bear markets, one needs to look at their returns during the Great Depression. Below is a graph that shows the yields on these bonds (rated Baa). As yields rose from 5.5% to 11%, bond prices fell significantly. Investors preferred safety during this time, and corporate bonds were not necessarily the safest of investments since a bondholder may lose money if the company goes bust. However, it might not be a bad strategy to buy Aaa rated bonds, which are much safer and carry much less risk. These bonds did not fall much in price during the depression and recovered the losses soon after. Conversely, the junk bonds are one of the worst investments that could be made during Deflation.

Also, the government debt of other countries, no matter how stable and responsible the government is, is not a good investment despite the absence of credit risk. The exchange rate between the US and that currency is likely to change in the favor of the US Dollar, thus lowering your overall returns or possibly causing a loss.

Preferable investments:

When there is deflationary fear in the market, people prefer safer investments that would not lose value during the crisis. One of the best investments of that kind is the US Treasuries. The US Government debt is the safest investment in the world, and is usually turned to during recessions. As people buy the government debt, its price rises, leading to capital gains. For example: The 30 year Treasury bonds returned 20% in 2008.

One may also buy safer businesses that do well and are immune to recessions. One such business is the Hard Money Lending business. These Hard money lenders make heavily collateralized loans to businesses on a short term basis, thus keeping the credit risk low. Many of the hard money lenders benefitted from the lack of conventional bank loans, thus seeing an increase in business.

Disclosure: None