How to Invest in Bonds and Bond Funds During a Market Correction

With interest rates low, investors are having a harder time finding both safeties and return on investments. Investors are willing to accept lower returns on bonds in exchange for safety, but near-zero interest rate levels have traditional bondholders seeking yield elsewhere.

Rather than lament the low yields, why not look for undervalued bonds during a market correction? More bond market corrections have taken place since the market lost 15% in 2009, despite the new level of volatility, bonds are still considerably less volatile than equities.

Bonds still provide a comparatively low-risk investment and baby boomers are piling into them ahead of retirement. Global bond funds are down less than 3% year to date, whereas many global equity funds have losses in the double digits.

Bond returns are so predictable they are, ho-hum, considered boring. Investors still face a trade-off between risk and return when investing in bonds. Low credit quality bonds are cheaper and can produce higher returns, but they have a higher risk of default. Higher credit quality bonds are more expensive but generally deliver reliable returns. These boring securities have saved many portfolios from large devaluations when equity prices have fallen.

ETF Bonds – Throw Out the Junk

Investors have rushed over to high yield bond exchange-traded funds (ETFs) in a search of yield. ETFs have stock-like features that can introduce additional risk when invested in lower grade bonds. High yield bonds are better known as junk bonds because the credit quality of the underlying bond issuer is low. The quality of the underlying securities can fluctuate more dramatically than, say, high-grade government or corporate bonds. This can put the investor at risk because unlike a mutual fund, ETFs trade continually throughout the day, often without a complete picture of the value of the bond fund holdings.

The market correction is a good opportunity to pick up bond ETFs trading at a discount. If you still want to dabble in high yield bond ETFs, a large secondary trading market has developed in some of these junk bond funds. The more liquid the secondary market, the easier it will be for you to buy and sell the bonds if they lose value from a credit default or other event.

Related: The Differences between A Bond and Bond Fund

Government Bonds – Be Prepared for the Interest Rate Lift Off

Interest rates are starting to edge up after falling to historical lows after the 2008 financial crisis. Central banks control interest rates like a puppet on a string by raising interest rates or buying up bonds to increase the value of their currency, or lowering interest rates and selling bonds to decrease it. Many countries are starting to slowly notch up their interest rates using various intervention mechanisms.

Gradually rising interest rates and the timing of the recent market correction could be used to your advantage. The fall in equity market prices following the August Chinese market correction has given bond prices a lift. Bond yields, as expected, are falling as bond prices are rising. This has created some attractive buying opportunities in government bond markets.

US treasury bonds, in particular, look interesting. Yields are currently low, but in December the US Federal Reserve is expected to start raising interest rates. In anticipation, yields are falling on some high yield bonds. Yields on long-term treasury bills are expected to nudge up gradually.

Foreign Bonds – Stick With Investment Grade

Foreign bonds can be the frothiest. Even before China’s stock market correction, bond prices were bouncing around more than usual due to volatility in currency prices. Currency markets have entered a new era of volatility. Analysts are divided on whether the new year will bring more stability or if this is a new normal in currency volatility.

One strategy that is providing some safety in international and emerging bond funds is to stick with investment grade bonds. Barclays International Aggregate Bond Index, hedged, has positive returns on the year. BlackRock is launching the iShares Core International Aggregate Bond ETF (IAGG) to track Barclay’s investment grade bond index.

Mortgage Bonds – Invest in Higher Credit Quality

US banks are still settling billions of dollars in claims for selling the low-grade mortgage-backed securities that were at the centre of the 2008 financial crisis. Most of the financial industry is seeking to distance itself from these toxic securities. Today, mortgage default rates are much lower. Singapore mortgage borrowers have been hit by the rise in the Singapore interbank offered rate (Sibor) in 2015, yet less than 1% of mortgages are in arrears of more than 30 days in Singapore, according to the Monetary Authority of Singapore.

The top eight mortgage-backed securities ETFs tracked by ETFdb.com are all up on the year, making mortgage bonds one of the best performing sectors during the market correction.

Corporate Bonds – Do Not Be Misled by High Premiums

High premiums are being offered to entice you to buy. Following the market correction, investors are demanding higher premiums in exchange for accepting lower grade corporate bond issues. Think before you leap into junk bonds. If the US Federal Reserve lifts interest rates next month, a flight to quality could follow. High yield bond values are likely to fall. Several industry sectors did better than others. We have previously touted clean energy and socially responsible investing as growth sectors. The Barclays Global Green Bond Interest is up 1.88% to date, while many bond funds are in the red. Pharmaceuticals and biotechnology are also performing well.

Read: Is a high yield bonds portfolio the right tool for a low-interest rate environment?

Retirees to the Rescue

Over 10,000 baby boomers are retiring a day, and even more, are increasing bond holdings in their retirement portfolios to prepare for retirement. As investors near retirement age, they shift their investment weighting from stocks to bonds. This increased bond buying activity will place a floor on bond prices and keep them stable. Target-date funds are accelerating the bond-buying activity of investors across all generations. These funds gradually shift the allocation of retirement portfolios into more bonds than equity as an investor age.

The common theme across all bond sectors is to go bargain hunting in the aftermath of the correction while yields are lower.