Ever since the onset of COVID-19, the financial markets have been turbulent, to say the least. Everything from stocks to alternative investments seems to be in a freefall. Everything except treasury bonds, that is.
Bonds have been doing considerably well ever since the start of 2020. Even without the recent pandemic, treasury bond prices were rising. However, the turmoil that has ensued recently has made an ever-increasing number of people worry about their portfolios. This has caused bond prices to soar.
As such, we explore whether treasury bonds are the best place for your money right now. We look at the positives, negatives, and discuss how can you diversify your portfolio in these days.
How The Fed Impacts Bond Prices
First, a quick primer on bond prices. Prices of outstanding bonds move in reverse to the yield on newer issues. When the Federal Reserve cuts the interest rate and the yield on newer bonds falls, the price of older issues increases to bring the yield around the level of newer issues.
Simply put, a fall in interest rates means that outstanding bonds increase in value and vice versa. Of course, an increase in demand for bonds will also push the prices above.
Another important detail to remember is that an interest rate cut also helps push stocks upwards, as bonds become unfavorable at lower yields.
Those looking to understand treasury bond in detail can start here.
The US Economy is in Dire Straits
At the time of writing, the S&P 500 has fallen around 18% from the start of the year. The fall began in the middle of February when the imminent danger of COVID-19 became apparent.
While this looks bad, the future could be even worse. Scott Minerd, CIO of Guggenheim Partners, says that S&P 500 could plunge to 1500 in a “worst-case scenario”. Of course, the chances of such a scenario occurring are slim, but the statement shows how even smart money is fearful of where the economy may go next.
The main reason this has happened has been due to the economic shutdown. Of course, the US is not the only one in a crisis right now. UN estimates predict an economic loss of $2 trillion in 2020 due to the pandemic. With the vast majority of businesses in disarray, investors have tried to reduce stock holdings in their portfolio.
Conversely, we have seen the 10 Year Treasury yields fall off a cliff as investors flock to purchase bonds in increasing numbers. Bond yields were already falling steadily at the start of the year, but the middle of February is when they really took a dive.
What does this mean for bonds as an investment? Let’s find out!
Why Treasury Bonds Are a Good Investment Right Now?
We can attribute the positive outlook of bonds to two reasons. Let’s look at them in a bit more detail.
Stocks Are Risky
Fundamentally, stocks represent an ownership stake in a business. The outlook of businesses is glum, to say the least. It is obvious that businesses are going to suffer as a result of the shutdown. Stocks are falling as a result.
Even though the $2 trillion stimulus package has eased the downward pressure on the market, it is doubtful if that will be enough.
The main reason for the stimulus not being enough is the current corporate debt. While it is only slightly higher than its 2008 high, chances of government bailouts are slim this time around. In fact, the US economic policy seems to be doing more harm than good in this regard.
You need to keep in mind that we have no idea how long it will take for normal business activity to resume. Until that happens, you should not expect a rebound in the stock market.
Wall Street Expects Interest Rate Cut
Even before COVID-19 became a problem, an interest rate cut was expected. Even though we saw the Fed cut rates on 15th March by 100bps to 0.25%, the chances of rates increasing are slim at best.
One increasingly real possibility is that a slowdown in business activity may lead to a deflationary economy. This may happen because people who aren’t making money anymore will begin to spend less.
As demand begins to fall, prices for goods will decrease. A deflationary economy will make increasing rates a very damaging move. In fact, deflation could even lead to negative interest rates.
Do remember that the $2trillion stimulus package is bound to be inflationary in nature. In the end, whether inflation occurs or not will probably be down to the loss in business activity and spending compared to the money added by the stimulus package.
The Dangers of Investing in Treasury Bonds
Remember that no outcome is set in stone. It could very well be that bonds show a sub-par performance over the next couple of years. Here is why that could happen:
Stimulus Package Incites Inflation
If COVID-19 fears subside in the near future, the additional money pumped into the system by the Fed could lead to inflation down the line. When that happens, chances are that interest rates will rise to cope with it.
In this case, bond yields will increase and the fall in the price of outstanding bonds will be immense.
This is dependent on how quickly the US economy starts to recover. So, investors who increase their bond holdings need to keep a close eye on where the economy is heading.
Outlook on The Stock Market Turns Optimistic
Even if we do not experience inflation, there is a chance that a bond investment does poorly. This could be due to people flooding money back into stocks once normal business activity resumes.
If this happens, then chances are that many people purchasing bonds right now will be selling them in order to increase their stock holdings. Once again, this requires bondholders to be vigilant of where the economy is heading next.
You Could be Late to The Party
Lastly, there is also a decent chance that the vast majority of gains that bonds could experience have already occurred.
Bonds could still do better than stocks and other asset classes. However, any gains experienced will be marginal to the ones in the last few months. It is important to keep this in mind!
Conclusion: So What Should I do?
As is generally the case, you should try to strike a balance between stocks and bonds. However, the percentage of bonds in your portfolio should be based on your outlook on the economy.
The main factor that you need to consider is the effect that COVID-19 will have. If businesses stay shut and economic activity stays at a minimum, then bonds should do well. However, there is a strong probability that bonds will fare worse once the economy returns to normal.
It’s not a bad idea to have a significant portion of your portfolio in bonds. However, it is paramount that you pay careful attention to the economy. Chances are that you will need to make considerable changes in your strategy once the pandemic is over.
How to Invest in Treasury Bonds?
If you expect bond prices to rise even further in the future, then it is best if you prioritize long-term treasury bonds. The longer the maturity of the bond, the more sensitive it will be to interest rate changes.
However, those who just want to protect their portfolio from uncertainties currently facing the market should probably go for short-term bonds instead.
Another option to consider is a bond ETF. An ETF with bonds of varying maturities will do well when yields are falling. A very good option could be an ETF that invests in both treasuries as well as AAA/AA-rated corporate debt. This ETF will offer adequate diversification and a higher return than one that only invests in government debt.
Lastly, remember that you do not have to hold bonds to maturity. The tide may very well turn in favor of stocks. When that happens, you should be able to sell the bonds at a profit and rebalance your portfolio.
What About Stocks?
Not having any stocks in your portfolio is almost always a bad decision. According to investing legend Benjamin Graham, your portfolio should have a minimum of 25% stocks at all times (and a maximum of 75%).
Over the last few years, many analysts have claimed that the stock market is overvalued. These analysts include Michael Burry, who predicted the 2007-8 crash. As such, a good number of analysts were predicting a crash even without the advent of a global pandemic.
The good news is that many stocks have experienced large losses. As such, some of them are undervalued as of now. This is a bargain hunter’s dream, and value investors will be trying to scoop up undervalued issues in full force.
This is what you should do as well! Try to look for companies whose sales would return to normal along with the economy. As long as you can purchase the stock at a reasonable price, chances are you are bound to do well in the long-term.
Another thing you can do is purchase an index fund. Passively managed funds are a great investment when the market is down. They do not require any research on your part and provide adequate diversification. However, be careful as the market may go down further before it goes back up!