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As we record this episode in early June, the markets are down significantly from their 2021 highs. Year-to-date, the S&P 500 is down about 15%, while the tech-heavy NASDAQ is down about 24%. For many of our investors, this downturn is uncomfortable but understandable. We understand that stocks go down too. After years of great returns, we knew that at some point we would be seeing declines like these. Experienced investors are not upset about the stock market going down. What is confusing, however, is the fact that bonds are down too.
- Aren’t bonds supposed to go up when stocks go down?
- Why are bonds not doing well?
- What should we do about the decline in the bond market?
- Does the bond market meet the advice of Ecclesiastes 11:2?
These good and important questions will be addressed in this episode.
What do investors typically run to when stocks are down?
Bonds! Bonds typically go up when stocks go down
In order to balance out risk, bonds are used as a hedge against market declines. Normally, when investors are concerned about their prospects in the stock market, they look to bonds to park their money. They figure that the small growth offered by bonds would be better than losing money in stocks, at least while stocks are still falling.
There are at least two factors causing bond values to increase.
- Bonds go up when there are more people buying bonds than selling bonds. The laws of supply and demand have an effect on the current value of bonds and bond funds. This could happen because investors who hold cash want to get a better interest rate or because stock investors want to consolidate their holdings into something “lower risk”.
- Bonds go up when the Federal Reserve reduces the federal funds rate (an important interest rate that affects other interest rates like mortgages and bank savings rates). When this rate drops, it makes older bonds with higher interest rates look more attractive and fetch a higher price.
Generally, when stocks struggle, investors flee to the relative safety of bonds. But that’s not exactly what we are seeing now.
We know that bonds do a better job at mitigating risks than stocks, but why are bonds going down with the stocks?
There are several factors contributing to the current slump in bond prices. First, the Federal Reserve Bank (the Fed) is causing the price of bonds to drop because it is no longer purchasing bonds but is rather selling bonds that it has been holding over the past several years. Think about the laws of supply and demand. When the available supply of a product increase it’s price tends to go down.
Second, inflation has become a major problem for the average consumer. One of the most important jobs of the Fed is to help maintain stable (gently rising) inflation. For years, inflation has been around 1-2% rather than the 3% target. Now that inflation is up to 8.3%, the Fed is really trying to get ahead of inflation by increasing interest rates (federal funds rate). This has a direct impact on the value of bonds. As interest rates increase, bond prices tend to decrease.
It seems like a perfect storm. The Fed is selling bonds while at the same time, it is increasing interest rates. This is in large part, why bond funds are really struggling even while stocks are falling. The conventional wisdom about bonds doing well when stocks decline is not holding up in this kind of environment.
What are you doing, as a financial advisor, to help your clients steward their bond holdings well?
This is one of the greatest sources of frustration for the Advisory team here at Life Financial Group. Our clients have hired us to assist them in stewarding God’s wealth. In order to manage risk, we (and every other financial advisory firm out there) use bonds. What should we do when bonds misbehave? The following are the way that The Life Group approaches this challenge:
- Pray: The future is fundamentally unknown to us. We don’t know when or how all of this will get resolved. Rather than causing us to wring our hands in fear, we turn to the Lord who knows the end from the beginning. God knew we would be here today facing this uncertainty. He knows exactly what is going to happen next. We trust that because God is good He will grant us wisdom as we follow Him. We can agree with this quote from 2 Chronicles 20:12, “We do not know what to do, but our eyes are on you.”
- Gather Information: We have been reading articles and talking with bond experts about what we should expect moving forward.
- Discuss: The advisory team has spent hours discussing the problem and different responses that could help resolve some of the volatility.
- Implement Changes: Once we understand the problem and the potential solutions, we then make the changes in our managed portfolios. For those using our BRI models, this happens automatically. Our Advisors are reviewing accounts and will make changes as they see the need for changes. Here are four kinds of changes we are making:
- Increasing cash positions.
- Utilize tactical bond holdings.
- Using bond managers that closely follow trends.
- Continue using normal strategic bond funds.
“As a Christian investor, we must be convinced that the Lord will provide for all of our needs”
- Continue to trust in the Lord
- Diversification is the key in times like this!
- But divide your investments among many places, for you do not know what risks might lie ahead. (Ecclesiastes 11:2, NLT)
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