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How Bonds May Perform When Rates and Stocks Fall

How Bonds May Perform When Rates and Stocks Fall

September 22, 2020
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A few weeks ago we looked at how different bond sectors performed during rising rate periods during the last economic cycle (2009–2020). Today we look at falling rate periods—not the outcome we expect, but it can still be helpful to understand how investments respond to different environments.

As shown in the LPL Chart of the Day, there are really two stories to tell: During broad falling-rate periods (the top half of the chart), declining rates supported a wide range of bond sectors, although, not surprisingly, the most interest rate-sensitive sectors tended to lead. But when rates fell during periods of stock market uncertainty (the bottom half of the chart), it was often a time when the diversification benefits of Treasuries stood out.

“It’s a tough time for bond investors,” said LPL Financial Chief Investment Officer Burt White, “because Treasuries, which are usually the best way to play defense, are also vulnerable to rising rates and have very low yields right now.”

View enlarged chart.

While riskier bonds, such as high-yield corporates and bank loans, have actually posted gains during falling-rate periods during the last economic cycle, higher-quality sectors, which also tend to be less risky, have generally outperformed. During the six stretches in which the S&P 500 Index declined at least 10% between 2010 and 2020, however, riskier bonds saw losses on average, while Treasuries led. There was one period of stock declines in early 2018 when inflation concerns were one of the catalysts. During that stock market decline, rates actually rose slightly, and none of the bond sectors shown above provided a safe haven for investors. While we think inflation will be contained in the near term, this scenario may become more important as the new cycle ages.

There’s an important lesson in the overall pattern. Even when positioning for a rising-rate environment, some core bond exposure, including Treasuries, can help provide important ballast. If rates do run higher because of strong economic growth, potential stock gains may be able to offset bond losses. Overall, we still recommend bond positioning that is underweight Treasuries, but no matter what the expected environment, there’s still a good reason for bond investors to emphasize high-quality bonds.

 

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