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Markets in one of the three main categories of bonds -- corporate, municipal and sovereign debt, such as U.S. Treasuries -- can be analogous to a canary in the coal mine in terms of financial health. For investors like you, a massive market sell-off can have significant implications. A sell-off in the bonds of one entity, such as a public company, will have narrower consequences.
A large move by investors out of government-issued bonds is a sign that individuals, banks and institutional investors have lost confidence in that government's ability to pay its debts. This happens most often when a country spends too much money and collects too little in taxes. Recessionary economic climates can exacerbate this situation and cause a government to devalue its currency or even default on its bonds. A devaluation of currency makes a country's bonds worth less money; if you own that country's bonds and suspect the country may choose that policy option, you will sell your bonds. So will everyone else -- all with the goal of recouping at least some of the money invested in those bonds and moving it into the bonds of a more stable government, into commodities like gold and silver or simply into cash. If a country defaults, as opposed to devaluing, you will lose all or most of your investment.
Corporate and Municipal Sell-off
A marketwide sell-off in either corporate or municipal bonds can follow a massive sovereign debt liquidation. If investors don't trust the country's government to pay its debts, that country's corporations, states and cities become suspect as well. More often, a marketwide sell-off in these bonds is accompanied by troubling economic news. A bad economy means lower earnings for companies and a shrinking tax base for municipalities, making it harder for each of them to pay their bills, which lowers the value of the bond.
As an investor, you should realize that this kind of massive correction can create a buying opportunity. The bonds of strong companies and local governments that have little risk of default may get swept up in the panic that is created by markets in turmoil. The price of those bonds could rebound swiftly, like an incoming tide, when the hysteria recedes.
A massive sell-off can also occur in the bonds of an individual company, city or state. There are myriad reasons why one of these entities may fail and cause a run on those individual bonds, but the reasons that occur most often are fiscal profligacy, a poorly thought out or executed business plan and blatant fraud.
- Panic Button image by Haris Rauf from Fotolia.com