The premise sounds reasonable enough. If a market crash is on the horizon, playing a little defense makes sense. Bonds are (supposedly) much safer than stocks. So, dig in.
If there was ever a time to ignore this line of thinking, now is it. While bonds and bond funds like the iShares Core U.S. Aggregate Bond ETF (NYSEMKT:AGG) or the Vanguard Total Bond Market ETF (NASDAQ:BND) may offer stability that stocks simply can't, we're in a once-in-a-lifetime situation that maximizes the weaknesses of bonds while minimizing their strengths.
Interest rates are ridiculously low
Fixed income investors and recent mortgage borrowers know -- interest rates are stunningly low right now. The average rate on a 30-year mortgage now stands at less than 3%, versus pre-2008 norms ranging anywhere from 5% to highs in the early 90s of around 10%.
Yields on government-issued debt are no better; 30-year paper is paying less than 1.5%. Even investment grade 10-year corporate bonds are only paying interest of just a little over 2% at this time, down from a more typical range of between 3.5% and 4% a few years ago, and between 5% and 7% a couple of decades ago.
In short, given interest rates that may or may not even keep up with inflation, tying money up in a bond at this point in time doesn't make a whole lot of sense for most investors (and particularly for investors only worried about the next few weeks). Cash and money markets sport weaker returns right now, but in the current economic environment, there's a lot to be said for liquidity.
If rates are going anywhere, it's up
Veteran investors have probably heard it before: When interest rates go up, bond prices go down, and when interest rates go down, bond prices go up.
U.S. interest rates aren't expected to rise anytime soon. In fact, the Federal Reserve recently suggested its foundational Fed Funds rate would probably remain near its current level at least through 2023 as a means of stimulating the economy.
But this rate is even less likely to move lower. Currently targeting a range of between 0% and 0.25% (effectively 0.13%), the Fed Funds rate would have to move into negative territory if the FOMC deemed the economy wasn't doing well enough on its own. Never say never, but a drastic move such as that one can lead to far bigger problems the Fed would probably prefer to avoid.
Largely being overlooked right now, however, is the prospect of inflation that could force the FOMC to push interest rates upward even if the economy isn't quite healthy.
See, rampant inflation makes economic growth even tougher to achieve, but that doesn't mean it isn't a necessary maneuver.
It's not an apparent threat yet, for the record. As of August, the consumer inflation rate stood at a very palatable 1.3%. But with the economic echoes of COVID-19 still ringing, a bunch of central banks all over the world are doing what they can to fully revive their economies beyond pushing rates even lower. If all that stimulus gains traction at once, inflation may soar before any of these banks can effectively quell it.
Not even TIPS are an exception
Given the only plausible increase in interest rates in the near future would be linked to rising inflation, it arguably makes strategic sense to step into fixed income instruments specifically meant to overcome the impact of higher consumer prices. Even this tactic wouldn't work right now, however.
These fixed income instruments exist in the form of treasury inflation-protected securities (TIPS). In simplest terms, TIPS are government-issued paper that adjust their biannual interest payments with respect to inflation in the U.S. If the official consumer price index measure indicates prices are rising, the Treasury increases the payout. Conversely, deflation leads to a lowered payout. TIPS funds like the Schwab U.S. TIPS ETF (NYSEMKT:SCHP) or the Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ:VTIP) -- both of which are more accessible to the average investor than TIPS themselves -- would behave as their underlying bonds do. A stock market crash wouldn't necessarily make a direct impact on prices of these bonds or funds, but the effort to rekindle the global economy after a major market setback could indirectly set the stage for rampant inflation.
Problem: The market has already priced this prospect in, and then some. Yields on 5, 10, and 30-year TIPS are now all in negative territory, suggesting investors have already made bets on uncontrollable inflation. Newcomers to TIPS bonds or funds would only start to break even on their 10-year TIPs, according to Charles Schwab, if annualized inflation holds at or exceeds 1.6%. That's an even bigger gamble than simply sitting tight and riding out any sell-off.
There's no free lunch on Wall Street
Bottom line? Taking action -- any action -- to avoid or even capitalize on a market crash feels smart. All too often, though, an effort to outsmart the market ends up backfiring. As Peter Lynch put it many years ago, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."
So if you're worried about a sell-off, the simplest thing to do may also be the best thing to do. That is, shed your overvalued and more questionable stocks, and park those proceeds in cash until the skies clear. The last thing you want is to be forced into selling bond holdings at a loss to scoop up newly created stock bargains.