When Stocks Swoon, Is the Bond Market a Good Bet?

Thursday was another up-and-down day for the stock market. Initially, major benchmarks moved up, seemingly threatening their record levels as investors focused on the prospects for potential stimulus measures. However, news that the incoming Biden administration might push tax rates on investments higher seemed to take the air out of the rally. The Dow Jones Industrial Average (^DJI 0.63%), S&P 500 (^GSPC 1.12%), and Nasdaq Composite (^IXIC 1.51%) didn't post major declines, but they remain below their all-time highs.

Data source: Yahoo! Finance.

Some investors are looking at the stock market and thinking that it might be time for a correction. The bond market has often served as a good alternative for those trying to keep their money working outside stocks. Yet with current conditions the way they are, it's fair to wonder whether bonds will fulfill their historical function -- or end up not being nearly as safe as some investors think they are.

What's happening with the bond market?

Bond investors are always worried about interest rates, and so today's comments from Fed chair Jerome Powell were directly on point. Powell said that he doesn't expect that current low interest rates will need to rise in the near future. In fact, he warned that trying to boost interest rates too quickly even if the economy starts to rebound could be disastrous.

Image source: Getty Images.

Today's comments were designed to try to put bond investors at ease. Powell indicated that the Fed would need to be very careful about making policy changes, because markets tend to react sharply to even the slightest change in the central bank's moves with respect to monetary policy.

The Fed has more direct control over short-term interest rates. However, to influence the long-term rates that govern key aspects of the economy, such as mortgage lending rates, the Fed has to take more extraordinary action. For years now, the Fed has made asset purchases, buying long-term government and mortgage-backed securities and thereby using market mechanisms to keep those rates lower than they'd otherwise be.

That practice was quite effective in 2020, sending long-term Treasury bond rates to their lowest levels in decades. However, since July, 10-year rates have risen from around 0.5% to above 1.1%. Rates are up almost two-tenths of a percentage point in less than two weeks.

Small moves, big money

Such a tiny rise in rates might not seem like a big deal. But small rate movements can cause big changes in bond prices. Consider: Since the beginning of the year, rates on 30-year bonds are up from 1.65% to 1.87%. Yet the price of the iShares 20+ Year Treasury ETF (TLT 0.37%), which owns those and similar bonds with long maturities, has fallen more than 4%.

A 4% decline for a bond ETF isn't necessarily a huge move. But many investors think that bonds aren't supposed to go down at all. Meanwhile, they point to the long-term gains that bond ETFs have posted recently, not realizing that much of those gains have come from price appreciation that resulted from the plunge in interest rates over the years.

Even interest rate stability would crush the total returns that many bond investors have gotten used to seeing. Interest alone on Treasury bonds amounts to less than 1% for most maturities. That's a far cry from double-digit percentage returns.

Be smart about bonds

Bonds do have a reputation for protecting investors from big swings in the stock market. But right now, bond rates are so low that there's more risk than usual in them. Investors need to be careful before assuming that having money in bonds will protect them from whatever could happen to the stock market in 2021 and beyond.