Recessions are broad-based declines in economic activity that last at least six months. Lower business activity leads to falling employment and retail sales, which leads to declines in corporate profits and stock prices. During periods of stock market declines, investors may favor bonds because they offer safety of principal and periodic interest payments. However, bond performance varies with the type of bonds and the severity of the recession. Of course, it's important to remember that the price of a bond rises as its yield, or effective interest rate, shrinks and the price drops as its yield increases.
The History of Recessions
The National Bureau of Economic Research has tracked U.S. recessions dating back to the 1850s. From 1980 to 2009, which is the most recent 30-year period as of this publication, the bureau has tracked five recessions with durations of six to 18 months: January 1980 to July 1980, July 1981 to November 1982, July 1990 to March 1991, March 2001 to November 2001 and December 2007 to June 2009.
U.S. government bonds include Treasury bonds and state and local bonds. Investors regard Treasury bonds as risk-free investments, with yields linked to the short-term interest rates set by the U.S. Federal Reserve. As the Federal Reserve Economic Data (FRED) graphs in the Resources section show, short- and long-term U.S. government bond yields generally fall during recessions because the Fed generally tends to lower rates to stimulate economic activity. However, if the Fed increases rates to slow down the economy and keep inflation in check, as it did in the early 1980s, bond prices fall and yields rise. State and local government bond performance during recessions has tracked that of Treasuries, with the exception of the 2007-2009 recession. The 2008 financial crisis created fears that even some state and local government bond issuers may not be able to meet their debt obligations, which led to a temporary flight of investments from state and local bonds into Treasuries.
Corporate bonds are riskier than government bonds. Ratings agencies, such as Moody's and Standard and Poor's, assign ratings to all corporate bonds. Bonds with higher ratings, such as "Aaa," usually indicate a lower risk of default than bonds with lower ratings, such as "C." Riskier bonds yield more because bond issuers have to pay a higher interest rate to attract investors. The FRED graphs show that high-grade corporate bond yields usually fall during recessions while low-grade corporate bond yields generally increase. Investors demand a higher yield for holding low-grade corporate bonds during recessions because companies with weak balance sheets are more likely to have difficulty meeting their bond obligations when economic conditions are tough. The 2008 financial crisis caused both high- and low-grade corporate bond yields to rise sharply because investors became exceedingly risk averse and moved funds to the safety of Treasuries.
Investors should hold bonds consistent with their risk tolerance and financial plan. Aggressive investors willing to tolerate some volatility could invest in low-grade but high-yielding bonds, while conservative investors might prefer high-grade government and corporate bonds. The key to long-term asset growth is to maintain a balance of bonds and equities, regardless of market and economic conditions.