How will Bonds Fare in a Depression?

Bonds are often seen as a safe alternative to stocks.  Indeed, the regular income provided through interest payments and the fixed term of the loan, after which the company will redeem the bonds for a fixed amount, reduce risk considerably.  Still, bonds are certainly not risk free, and many of the same factors that will affect the price of stocks will also affect the return from bonds.

Realize that a bond is simply a loan from a company that is sold on the open market.  The loan pays a fixed amount each year over the life of the loan  (typically paid semi-annually) but the return one receives depends on the price at which one buys the bond.  For example, if a bond pays 5% at $1000 per bond, because the amount paid is fixed, one would receive a return of 10% if one paid $500 for the bond.

There are two issues that make bonds especially risky right now, however.  The first is that interest rates are really, really low.  This means that people who have traditionally kept their savings in money markets and bank CDs have moved into the bond market out of necessity.  This has pushed the price of bonds higher, meaning that the return one would get is less.

In some cases, the price of bonds have climbed so high that they are above the redemption price.  This means you may end up paying $1200 when the company will only pay you $1000 at redemption time.  Companies may also recall the bonds early at the payoff amount.  If so, you will quickly lose the premium paid.

The other danger is that companies are far more likely to go bankrupt at this time than they have in the past due to new regulations and taxes.  When a company goes bankrupt, bondholders typically get almost nothing back.  (If you are lucky, you might get $200 for a bond for which you paid $1000.)  Many cities and states are also likely to go bankrupt over the next several years as high pension and healthcare costs begin to dominate the general fund.

Unfortunately, while bonds are a good hedge against volatility in the stock market, there is a lot of risk in the bond market at this time.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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