The Truth About Bond Market Volatility and Mitigating Risk

February 13, 20237 min read
The Truth About Bond Market Volatility and Mitigating Risk
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Key Takeaways:

  • Governments and corporations issue bonds when they wish to raise money.
  • The chief difference between stocks and bonds is stocks give investors partial ownership, while bonds are loans.
  • While bonds are generally considered less volatile than equities, they do carry risks.

With recent market volatility, many investors are wondering whether it is a good time to shift their focus from stocks to bonds. While bonds are generally considered less volatile than equities, they still carry risks. To help investors make informed decisions in this regard, this article answers key questions about investing in bonds and some alternative options investors have to mitigate risk exposure.

What are Bonds?

Governments and corporations issue bonds when they wish to raise money. As such, they serve as borrowers from investors. As fixed-income instruments, bonds are units of corporate debt and have maturity dates on which the principal owed must be repaid in full. Governments commonly use bonds to fund schools, roads, dams, or other infrastructure. Likewise, companies frequently borrow to grow their businesses, take on projects, purchase properties and equipment, or hire talent.

Types of Bonds

  • Government. These are issued by the government to support public spending. They include a pledge to pay periodic interest – coupon payments – and to pay back the face value upon maturity.
  • Municipal. These debt securities are issued by state and local governments, often to fund capital expenditures such as the construction of schools, highways, or bridges.
  • Corporate. These bonds are issued by corporations to fund expansions, capital improvements, acquisitions, or debt refinancing.

Bond Market vs. Stock Market

The chief difference between stocks and bonds is stocks give investors partial ownership, while bonds are loans. To generate profit, stocks must increase in value and later be sold on the stock market. In contrast, most bonds pay a fixed amount of interest over time.

Should I Buy Bonds?

In a market in which inflation remains problematic, and the Federal Reserve has been raising interest rates to combat high prices, bonds can be an attractive alternative to a volatile stock market. After all, bonds have a relatively low correlation to stocks.

But is it that simple?

On the plus side, bond yields have risen meaningfully, their prices are relatively fair and they have the potential to offer respectable gains. Meanwhile, large-cap stocks remain too pricey. As a result, the reward for buying stocks over bonds seems relatively small.

However, there are risks associated with bonds, though, including:

  • Interest rate risk. Rising interest rates are a top risk for those who invest in bonds.
  • Credit risk. There is always the risk that an issuer cannot make principal or interest payments when they come due.
  • Inflation risk. Inflation has the effect of lowering the buying power of a bond’s future principal and coupons.
  • Reinvestment risk. When interest rates are falling, investors might need to reinvest their principal and coupon income upon maturity at lower rates.
  • Liquidity risk. There is the possibility that investors may have trouble finding a buyer when they wish to sell. In that case, they might have to sell at a big discount to market value.

How to Buy Bonds

Bonds can be purchased through the U.S. Treasury or a brokerage. With the former, one can find savings and Treasury bonds. Brokerage platforms offer Treasury bond funds and municipal or corporate bonds. Bonds may also be bought
through discount or full-service brokerage channels, as well as directly from the issuer.

Note that broker commissions can range from 0.5% to 2%, and that some specialized brokerages require lofty minimum initial deposits of $5,000 or more. There are no fees or commissions when buying bonds through the government’s TreasuryDirect site.

Bond Market Crashes

While bonds have a reputation for being more stable than stocks (with lower returns), they can still crash. When interest rates go up, the price of existing bonds that pay lower rates decreases. Why? Because investors can make more from newly issued bonds. When rates go up very quickly, bond prices could fall at a commensurate speed, resulting in a crash.

They don’t garner as many headlines as stock market crashes, but bond crashes have happened in history, including as recently as last year. The Bloomberg Barclays US Aggregate Bond Index, which represents most of the nation’s investible bond market, fell almost 13%. In 2021, when the Fed began tapering asset purchases following a pandemic-fueled recession, rising inflation caused the agency to increase rates seven times.

Then there was 1994, when the target federal funds rate rose by 25 basis points, the first such hike in five years. The vote by the Federal Open Market Committee caught investors – and the market — off guard, sparking a bond sell-off.

Mitigating Risk in Bond Investing

During this protracted period of economic uncertainty, many bond investors are looking to mitigate risk. There are a few strategies they can employ, including:

Investing in I Bonds. “I bonds” are known for delivering top-yield returns and carrying relatively low risk. Such bonds have both an inflation and fixed rate that is adjusted every six months.

Using a bond ladder. A bond ladder is a portfolio of bonds or certificates of deposit that mature on varying dates. This strategy seeks to provide income streams while guarding against exposure to rate fluctuations.

Portfolio diversification beyond bonds. Disparate investments combine to lower portfolio risk. In addition to bonds, that could mean owning stocks from a variety of countries, industries, and risk profiles. It could also mean mixing in other investments with low correlation to stock markets.

This can also mean diversifying portfolios with alternatives – assets other than stocks, bonds and cash. Largely unregulated by the Securities and Exchange Commission, alternatives were only available to those who could meet high minimums in the past. That has changed with the growth of platforms such as Yieldstreet, which offers accessible, curated opportunities in a number of alternative investment vehicles.

Fund managers, financial planners and seasoned investors increasingly agree that to mitigate risk, one important move investors can make is to diversify their portfolio with assets that are not directly tied to ever-changing public markets.

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Diversifying with Alternatives

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

While bonds are generally considered more stable than stocks, they may entrap investors searching for safe investment solutions during protracted economic instability. However, there are other ways to lessen risk during times of volatility, including diversifying with alternatives.

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