Beware the danger of using traditional U.S. bonds as a hedge in today’s market economy! As you’re likely aware, the past week was pretty eventful for the stock market. One of the main triggers that prompted this activity was the concern over a bear market in bonds. As I’ve talked about before, when interest rates go up, bond values go down. There’s been growing concern that inflation’s around the corner – we haven’t had any real inflation for quite some time. And so, that concern was one of the main factors that created the spark and led to the stock market volatility we saw.

The reason most people have bonds in a portfolio is to help hedge risk. Therefore, when markets show signs of extreme volatility, people inherently rush to the safety of bonds. In the short term, this causes bond prices to temporarily rally. But you have to be careful here – beware the bond bear.

There’s no question in my mind that we are on the front end of a bear market in bonds, and what may end up being a historic bear market in bonds. Think about this – interest rates have been very, very low. When interest rates are low, that means bond prices are high. One of two things will happen with interest rates:

  • they’ve either got to stay really low, in which case bonds aren’t paying anything,
  • or interest rates are going to go up, and bonds are going to do even worse. 

Don’t be confused: there are a lot of categories of bonds, but I’m talking specifically about traditional U.S. bonds here. Traditional U.S. bonds (including treasuries, investment grade corporate bonds, and investment grade municipal bonds) are commonly held in bond mutual funds. These are doomed to failure over the next 15-20 years.

Overall, we need to be smarter about how we look at our investments. There are so many different ways to hedge market risk beyond traditional U.S. bonds. There’s non-traditional bonds, in which there are 5 or 6 categories alone, and those have the ability to go up with rising interest rates rather than down. Foreign bonds are also a good hedge against the U.S. dollar. Asset classes such as commodities and energy can sometimes be an effective hedge against the stock market. Ultimately, the way we create more stability in our portfolio is by having diversity, so that when one asset class zips, another class zags. That means that when U.S. stocks are way down, hopefully not everything in the portfolio is way down.

When you’re under the age of 45 and you’ll continue investing until you’re 65, you don’t have to worry about stock market volatility too much. You want to go with the stock market, because over 30 years, highs and lows are going to ride themselves out (as long as you stay invested and don’t get in and out all the time). As you get closer to retirement, however, you need to start creating more stability in your portfolio. Just be careful about using traditional U.S. bonds as your only source of stability – they can slowly erode your financial health as interest rates increase over time.

Beware of the bond bear and how you use bonds as a hedge against the type of volatility we are currently seeing in the stock market.