Are Bonds Safe During a Recession?

Some of them can be a safer bet in recessionary times, but not all bonds are created equal.

Written by Erin Gobler / July 1, 2022

Quick Bites

  • A recession is characterized as a decline in economic development over many months, usually accompanied by a declining GDP and rising unemployment.
  • Bonds are a type of debt security that companies and governments use to borrow money from investors in exchange for regular interest payments.
  • Bonds have many advantages during a recession, but they also have some risks that investors should consider.
  • Bonds can be beneficial to have in your investment portfolio, however, your allocation during a recession doesn’t necessarily need to be higher than at any other time.

Some bonds can be safer during recessions; others, not so much. Bonds, which are basically loans from investors to corporations and governments, but are bonds really safer during a recession? We spoke with one investment expert to find out. Keep reading to learn more about how bonds and recessions work, and the benefits and risks of investing in bonds during a recession.

Inside this article

  1. What is a recession?
  2. What are bonds?
  3. Are bonds safe in a recession?
  4. Why might bonds be safe?
  5. Risks
  6. FAQ

What is a recession?

A recession is a period of decline in economic development that usually lasts less than a year.

Recessions, which are roughly considered to be any two consecutive quarters with a negative GDP. When the country enters a recession, we are likely to see a decline in gross domestic product (GDP, the value of goods and services produced in the country), reduced wages and jobs lost, and reduced business activity, including production and sales. For individuals, one of the most indicative characteristics of a recession is seeing friends and family, if not themselves, losing their jobs.[1]

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It’s a normal part of life, meaning it’s best to get used to the idea because you’ll more than likely experience at least one in your lifetime.[2]

What are bonds?

Think of a bond like a loan. It’s a security (a financial asset) that’s issued by a corporation or government entity as a way of raising money.

Bonds come in many different forms that can generally be broken into three categories:[3]

Corporate bonds

Corporate bonds are issued by public and private corporations. Interest rates on corporate bonds are affected by the creditworthiness of the issuing company. If a company is top-notch, it may pay less.

On the other hand, a high-yield bond— also known as a junk bond — is one that pays well but because it’s issued by a company with a lower credit rating, there’s a higher risk they won’t pay.

Municipal bonds

Municipal bonds can be issued by states, cities, and counties. One type of municipal bond is a general obligation bond, which is unsecured debt that government entities use for a variety of purposes. These bonds are usually paid back by tax dollars the entity collects.

Government entities also issue revenue bonds, which can be used to finance a particular project and are typically paid back using the revenue generated by these projects. If the project doesn’t generate the expected revenue, it could result in default.

Finally, conduit bonds are issued by municipalities on behalf of private entities like hospitals or universities. In this case, the conduit, meaning the organization the bond was issued on behalf of, must pay back the municipality. If it fails to do so, the municipality may not be able to repay the bonds.

Treasury securities

Treasury securities are issued on behalf of the U.S. Treasury Department. They are backed by the full faith and credit of the U.S. government, making them the safest of all types of bonds. Treasury securities fall into a few different categories, depending on the term and nature of the bonds.

One example is the I Bond, which pays a rate that is linked to inflation. With inflation raging in 2022, the I Bond is garnering much attention from investors seeking an outlet from stock markets that are flagging.

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Are bonds a safe investment during a recession?

Many people consider bonds to be a safe alternative to stocks. And considering the fact that recessions are often accompanied by stock market declines, it makes sense that investors would turn to bonds.

While it’s true that bonds are less volatile and tend to outperform stocks during a recession, that doesn’t necessarily make them a safe investment or mean that you should strictly invest in bonds during a recession.

First, as we discussed above, there are many different types of bonds. And while some—namely U.S. Treasury securities—are practically risk-free, others carry some risks.

Whether you should invest in bonds depends less on the state of the economy and more on your investment goals, says Robert Johnson, a professor of finance at the Heider College of Business at Creighton University. He recommends creating an Investment Policy Statement (IPS), where you set clear investment objectives and an investment strategy.

“The whole point of an IPS is to guide you through changing market conditions,” Johnson says. “It should not be changed as a result of economic or market fluctuations. It only needs to be revised when your individual circumstances change–perhaps a divorce or other unanticipated life change.”

Why might bonds be a safe investment?

The reputation bonds have of being a safer investment isn’t entirely unwarranted. They do have some key benefits that investors may find especially attractive during a recession.

First, bonds tend to be less volatile and generally outperform stocks during a recession. A bond is essentially a loan. You getting your investment back is dependent on the issuing entity repaying that loan. The chances of default are even lower when you’re talking about investment-grade bonds or those issued by the federal government.

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Another benefit of bond investing is that it provides a regular source of income. Most long-term bonds make interest payments to investors every six months. At a time when your stock investments are losing value and dividends may be falling, that interest income can be especially attractive.[4]

Risks

While bonds have some advantages, there are also some risks to consider. First, while bonds are less volatile than stocks, they don’t completely eliminate the chances of losing your money. After all, a bond is a loan, and bond issuers can default on their loans just like any other borrower can.

“Investors in corporate bonds, particularly junk bonds should be concerned with default risk,” Johnson says. “And, when the economy enters a recession, the likelihood of corporate defaults rises. That is, in a recession the likelihood of default is higher than during boom economic times.”

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Another risk of bonds comes as a result of fluctuating interest rates. As a bond investor, it’s easy to see rising interest rates as a benefit. But that’s only the case for people who are considering investing in bonds, not those who already have.

“For existing bondholders, rising interest rates are bad news,” Johnson says. “As rates rise, the value of already-issued bonds falls. So, if one is a current bondholder and rates rise (which often happens during a recession), the value of existing bonds falls.”

Another risk of bonds is their low returns compared to stocks. As we mentioned, bond investments tend to be less volatile than stocks. But that lack of volatility comes at a price. When the stock market is experiencing a bull market, bonds outperform stocks considerably.

So yes, you could protect some of your money by investing in bonds during a recession. But the stock market tends to be forward-looking, meaning stocks will likely start rebounding before the recession has even ended. And when that happens, you run the risk of having your money tied up in bonds rather than taking advantage of the large stock market growth that’s likely to happen.[5]

That’s not to say that you should invest in bonds at all during a recession. But it does support Johnson’s point that your investment strategy shouldn’t necessarily change whether the economy is in a recession or not.

FAQ

Can you lose money investing in bonds?

Yes, you can lose money investing in bonds, either if the bond issuer defaults on the loan or if you sell the bond for less than you bought it for.

Are bonds safe if the market crashes?

Even if the stock market crashes, you aren’t likely to see your bond investments take quite as large of a hit. However, businesses that have been hard hit by the crash may have a difficult time repaying their bonds.

What is a good alternative to bonds?

There are many different types of bonds, so rather than looking for an alternative to bonds, it might make more sense to simply choose a bond that best fits your investment goals.

Article Sources
  1. “Business Cycle Dating Committee Announcement January 7, 2008.” National Bureau of Economic Research. Jan. 7, 2008. https://www.nber.org/news/business-cycle-dating-committee-announcement-january-7-2008.
  2. “Business Cycle Dating.” National Bureau of Economic Research. https://www.nber.org/research/business-cycle-dating.
  3. “Bonds.” Investor.gov. https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds.
  4. “What is a bond?” Vanguard. https://investor.vanguard.com/investor-resources-education/understanding-investment-types/what-is-a-bond.
  5. “Understanding Bond Risk.” FINRA. https://www.finra.org/investors/learn-to-invest/types-investments/bonds/understanding-bond-risk.

About the Author

Erin Gobler

Erin Gobler

Erin is a personal finance expert and journalist who has been writing online for nearly a decade. Erin’s work has appeared in major financial publications, including Fox Business, Time, Credit Karma, and more.

Full bio

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