Myth… When Stocks Go Down, Bonds Go Up
Published April 1st, 2020
MYTH: When Stocks go down, Bonds go up.
FACT: Bond prices move based upon different dynamics than stock prices. It is very common to see bond prices drop on the same day as stocks.
Key Takeaways:
Bond Prices move based on different dynamics than stock prices.
Bonds are a safer relative investment to stocks, but during times of extreme financial stress, bonds can go down just like stocks.
A flight to cash can be bad for bonds just like it is for stocks.
Bonds pay interest, and bond funds pay regular dividends that are made up of the interest of many bonds.
In fact, high yield (aka junk) bonds often move in exactly the same direction as stocks - which is one of the reasons that we typically don't use them to buffer the volatility in a portfolio.
However - times of EXTREME financial stress - such as market panics or when the Fed or Federal Government announces significant changes in monetary policy, can cause quite a ripple in the bond markets. This is what we are seeing now.
CANNONBALL EXAMPLE: Imagine, if you will, a public pool like we all swam in as kids. One kid - not a great swimmer - is learning to swim, splashing around and gagging a bit. Another kid - is sitting on a floating doughnut with his feet hanging over the edge, drinking a Slurpee. Suddenly - a great big fat kid on the side of the pool screams "CANNONBALL" and jumps into the pool near them both.
The kid who is struggling is the stock market. He almost drowns, but with great effort drags himself to the side of the pool and eventually beats up the fat kid who cannonballed them.
The kid on the floating doughnut is the investment grade bond market. He gets a little bit of his Slurpee spilled on his stomach and bobs around a bit - but never was in any real danger and goes on to enjoy his Slurpee.
The great big fat kid yelling "CANNONBALL" is the Coronavirus - and our societal and government response to it. All of this is highly disruptive - almost to the same level we saw during the Great Recession.
This disruption is one of the reasons that we have not yet deployed the approximately $172 Million that we currently have sitting in cash. In our recent Recession Protocol Webinar, I mentioned we would see disruption and volatility in the bond markets. THIS IS NORMAL. There are 4 things that are moving the bond markets right now.
The Fed's lowering of interest rates and injection of billions, if not trillions of dollars into the markets to try to stave off what we believe is a foregone conclusion - recession.
A flight to cash - many investors have called their brokers and told them to "sell everything." What they are selling drops in price - and a lot of that is perfectly good bonds.
Bond traders taking extreme markups/markdowns on the price of these bonds in order to move them. I have seen literally 20% "commissions" on perfectly good bonds that very likely will pay on schedule - which is egregious but is also a reality.
Interest rate changes - while most of the individual bonds that we hold in PARAGON accounts have fixed coupons, some bonds within the mutual funds that we hold have "floating rate" bonds whose prices will drop when interest rates drop.
MARK-TO-MARKET Rules
We spent a great deal of time over the last year making sure that our fixed income holdings were of high quality. However, we cannot change that fact that whenever ANYONE, ANYWHERE sells a bond - be it a bond that YOU own as an individual bond - or bonds in a mutual fund - for a price lower than the MATH says that bond is worth - those bonds are "marked to market" across all accounts, all statements, and all digital dashboards throughout the world.
This does not mean that you should SELL any of these bonds or dump the mutual funds that hold these perfectly good bonds. Within weeks or months at the outset, the MATH behind these bonds (the cash flows, yields, etc) should revert back once normalcy is restored in the market.
Of course, some companies will go bankrupt and not pay on their bonds. However, this also was foreseen - which is why we were moved to higher and higher credit quality over the last year, intentionally moving away from bonds that we thought had a reasonable chance of being downgraded to junk status.
REMEMBER - YOU'RE GETTING PAID FOR YOUR SUFFERING
Unlike with many stocks - bonds PAY interest, and bond funds pay regular dividends that are made up of the interest of many bonds. So, while they'll fluctuate a bit, you still get the cash flows from them.
DON'T BUY THE DIPS - THIS AIN'T OVER YET!!
Obviously this is a highly fluid situation. Please keep in mind that Recessions take months to unfold and we don't have ANY real earnings numbers that reflect the impacts of business disruption yet - only projections and spin. In many cases, experts and analysts suspect that companies whose stocks went up the most last year may have some of the highest chance of financial difficulty going forward because a lot of that previously high stock price may have been a result of stock buybacks - which means these companies used all their cash reserves to pump up their own stock price. In particular, think McDonalds, Starbucks, Delta, Southwest, United Airlines, Boeing, and many others. IF they have to assume huge amounts of debt or take government loans... their stock may well not rebound quickly - if at all.
We have had a few clients calling or emailing about "this stock" or "that stock" and should they buy it because it is "cheap" now. The fact of the matter is that right now, YOU DON'T KNOW IF IT IS CHEAP. It is only cheap compared to what it was a few months ago. We have no revenue or earnings numbers on many of these companies going forward as a result of this unexpected, once-in-a-lifetime event, to base a "cheap" or "expensive" decision. That will come - but now it is purely speculation.
If a company gets "bailed out," it may very well be bailed out by the government taking a large position in the company - and issuing NEW STOCK. This is EXACTLY what happened to GM during 2008. Remember "Government Motors?" All existing stockholders were WIPED OUT and new "Government Motors" stock was issued at $35 per share in 2011. The current mood in Congress - especially among the Democrats - is "Fine - let's save the WORKERS and their jobs - but punish the corporations and their rich stockholders!!" The UAW has already made this their rallying cry. Likely we will not see "blank check" bailouts... but instead, government loans or stock purchases with rather punitive terms.
We are monitoring the situation daily and will continue to do so. Again - this will take TIME. A LOT more time than people think. We are already carefully crafting the "re-entry portfolio" in an attempt to get maximum returns - but with reasonable risk - when certain sectors start to recover. HOWEVER - again - this has to be done carefully. Investors who bought GM in 2009 at what they thought was a super-low price... lost 100% of that investment. In this case, the danger of "American Airlines" becoming "America's Airline" and being owned by the government, not stockholders - is REAL.
Thank you for your trust in us. We take it very seriously and appreciate it more than you know.
Best, Jon
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