The bond market is anything but simple. For starters, it is significantly larger than the stock market and yet it moves at a more stable, glacial pace. It is tied directly to the economic health of nations and is influenced by clear-cut fiscal policy and the laws of economics.
For this reason, it can be difficult to invest in bonds successfully during times of economic crisis and you may be uncertain about whether or not this is right for your portfolio.
So, in the context of the market, what are the factors at play?
For one, commodity prices rose as the US Dollar inflated and slipped in value. While this inflation may be transitory, this means that yield rates will have a curbed increase. In other words, making money too expensive to borrow would hinder economic recovery.
This is good news for the economy of advanced nations, but a tricky situation for long-term bond investors.
With the economy in flux, bond investors have to manage their assets carefully, as this is not a good time to sit back and let things run their course. Chaotic markets call for nimble management strategies, so let’s take a look at what you can do to optimize your bond investments.
Debt in Economic Recovery
Before diving into the fine details of bond investing during economic recovery, let’s consider the bigger picture so that we don’t miss the forest for the trees. Equity markets have recovered, the global economy has entered a tentative yet hopeful recovery, and so bond markets have naturally trended downwards.
During a major crisis in equity markets, money flows out of riskier assets and into more stable markets such as bonds. Historically, bond markets have served as a stabilizer or counterbalance to investors seeking to diversify their portfolio and reduce risk. When equity markets recover, they recover fast, and money flows out of bond markets into stocks.
As of writing, Ultra U.S. Treasury Bond Futures have dropped 40 points over 129 days, for a total loss of just under 20%. This is a natural consequence of the pronounced recovery in equity following the 2020 market crash, which has now slowed and stabilized into a relatively sideways movement.
Buying bonds directly from governments is not the only way to take on exposure to bond markets. It is also possible to short bond markets and take three-dimensional positions through derivatives like options on bond futures. Otherwise known as interest rate derivatives, these contracts represent the largest derivative market in the world.
As equity markets enter limbo, the future of bond markets aren’t crystal clear, but we can anticipate that financial policymakers may eventually need to raise interest rates to slow the economy down and curb inflation.
Unless you are willing to short bond markets, take on actively managed risk with short-term investments on brief upward swings, or structure complex derivative positions, it may be best to wait until equity markets and policymakers establish more distinct market trends.
Diversification
The dust has settled, and the global economy is on track to recovery. However, it is now permanently altered, but still showing signs of life and future growth. Fiscal policymakers are very hesitant to raise interest rates, as lower interest rates will encourage borrowing and allow cheap money to flow into the economy and stimulate economic recovery.
For this reason, investors cannot simply pour money into bonds and sit back while interest collects. Investors should allocate some of their money to riskier assets that promise growth and vitality while more index-correlated and policy-driven assets slow down. This means growth stocks, commodities, ETFs, derivatives, and other high-risk assets.
Keep in mind, investing in riskier assets does not mean taking on unnecessary risks. Being able to sustain and minimize losses consistently is key to succeeding in risk assets. This is an art and a science in itself for professional money managers, as are derivatives, but simply buying shares in index funds and growth-focused ETFs is very straightforward.
Some investment products to consider are the iShares Emerging Markets Local Government Bond Index Fund, International Government Bonds ETFs, MainStay MacKay High Yield Corp Bd A, and Additional Tier 1 Bonds. These products offer diversified exposure to bond markets.
Additionally, selling a futures contract on treasury bonds can offset the short-term risk that rising interest rates present to your bond portfolio. Your previously bought bonds will trade at a discount, but your short position in bond futures will offset, or hedge, your portfolio.
High-Yield Corporate Bonds
Corporate bonds reflect the shifting nature of debt in the private sector, while government bonds are based on the economic health of nations, corporate debt can be more varied and dynamic. Highly rated corporate debt is stable and reliable, it does not quickly change in value and is more closely tied to interest rates and market indices.
Low-rated corporate debt was once ignored by institutional investors, but the bond market evolved drastically when bond traders realized they could capitalize on the volatility of these so-called low grade investments. These bonds presented an opportunity in market inefficiency and this was often overlooked and inaccurately valued, allowing traders to make huge deals.
This means diversifying into the infamous credit-tied junk bonds. Rebranded as high-yield corporate debt, these low-grade bonds behave more like stocks than bonds, closely tracking the growth or failure of companies with room to grow and just enough assets to qualify for the bond market.
These bonds can balance your portfolio for risk. If interest rates stagnate or grow sluggishly, then credit assets like successfully growing low-grade corporate bonds with less correlation to government bonds and markets overall can provide the growth and returns needed to offset economic fragility.
In other words, smaller, more volatile high-yield bonds can go against the general trend of the market and offset losses incurred by poorly performing government bonds.
Invest in Shorter Time Frames
Buying treasury bonds can be described as lending money to the government. The longer the time frame, the higher the interest rate, as the loan becomes riskier and more difficult to repay. For this reason, changes in interest rates cause larger changes in the value of bonds with larger maturity rates. Higher maturity rates, higher volatility.
When bonds are unstable or losing value, owning bonds or bond derivatives with shorter time frames will provide increased stability to your portfolio. If bond markets are turbulent, your portfolio will suffer less from wild swings. Additionally, this will make your portfolio more nimble and instead of committing debt to longer time frames you can re-evaluate more frequently.
Featured Image: Megapixl
