By Paul J. Lim
February 20, 2018

If you’re an investor, you’re probably breathing a sigh of relief now that it looks as if the stock market selloff that spooked Wall Street this month is over.

But equities weren’t the only investments that fell — or that investors should be worried about.

Most types of bonds and bond funds have also suffered losses this year.

The average long-term government bond fund, for instance, is down more than 6% this year and more than 7% since late December. Corporate bond funds have fallen 2% this year and and around 5% since December. And high-yield bond funds have lost around 2% since the first week of January.

And unlike stocks, bonds aren’t likely to immediately rebound.

Why Even Modest Bond Losses Are Scary

To be sure, this year’s fixed-income losses haven’t been as flashy as the 10% plunge for stocks. That may explain why the bond market downturn has gotten very little attention.

But even “bad” bond market losses are always smaller than sizable equity market losses, just as fixed-income returns are more muted than stock gains.

What investors should really be worried about is that bonds are supposed to provide your portfolio ballast when the stock market sails into a storm, as it did earlier this month. Yet many fixed-income investments fell in lockstep with equities during this recent downturn — even though it’s their job to zig when stocks zag.

For instance, when the S&P 500 index of U.S. stocks fell 56% in the 2007-2009 bear market, a diversified portfolio of bonds gained around 7%. Similarly, when the broad U.S. stock market fell 49% as the dotcom bubble was bursting between March 2000 and October 2002, bonds gained around 26%.

How to Adjust Your Portfolio

Market experts suggest investors use this scare to make sure that their fixed-income portfolios are properly constructed so that they will provide adequate protection.

“The recent market weakness is a good reminder of one of the core tenets of our asset allocation philosophy,” said Katie Nixon, chief investment officer of Northern Trust’s wealth management business. “When the chips are down, the world is really comprised of two super asset classes: Risk Assets and Risk Control Assets.”

Bonds in general are considered “risk control” assets. However, some fixed-income investments — such as low-quality “junk bonds” — have historically acted more like stocks than bonds, said Lewis Altfest, president of Altfest Personal Wealth Management.

That’s why Altfest has recommended investors trim their holdings in junk bonds and other low-quality forms of debt, while shoring up their holdings in bonds that provide ballast, such as short-term Treasuries.

Why Bonds May Keep Sliding

Bonds are considered staid, conservative investments relative to stocks. But just like any other investment, they are securities that can be bought and sold on the open market, so their prices fluctuate based on the market’s mood.

And right now, that mood is changing.

“Throughout 2017, positive economic reports boosted the stock market without aggravating inflation fears or yield pressures,” says Jim Paulsen, chief investment strategist for The Leuthold Group. “Recently, however, good economic reports are starting to worsen inflation indicators, force bond yields higher and pressure the stock market.”

It’s also pressuring the bond market, because inflation eats away at the modest returns that bonds provide. Meanwhile, bond prices move in the opposite direction of market interest rates.

And the yield on 10-year Treasury notes has climbed to 2.90% this month, up from 2.06% last September. If inflation fears continue, Treasury yields are likely to climb above 3% in short order.

That’s why Paulsen believes “investors should be prepared for an arduous correction in both stocks and bonds.”

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