Beginner’s Guide to Market Volatility

3 investments that can 'act as a ballast' against stock market shakiness, according to a bond strategist

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Key Points
  • In 2008, the Bloomberg Barclays U.S. Aggregate Bond index returned 9% compared with a 36% loss in the S&P 500.
  • "Start looking at high quality parts of the fixed income market, which becomes important in this environment," says Gargi Chaudhuri, head of iShares investment strategies for the Americas.

When things start to get alarming in the stock market, investors typically begin looking for relatively safe places to hide. Traditionally, their favorite hiding spot has been in the bond market.

Because bonds are less volatile than stocks, holding bonds during times of stock market decline has proven wise for investors in the past. During the Global Financial Crisis in 2008, for instance, when the S&P 500 surrendered 36%, an index tracking the broad bond market returned 9%.

The difference in performance isn't always so stark, however. So far in 2022, that same bond index is struggling, having shed nearly 10%. That's better than the 16% slide in the S&P 500, but it's not exactly the safety blanket that investors are hoping for.

Just as with the stock market, things have been a bit weird for bonds lately. For one thing, the Federal Reserve has been hiking, and looks poised to continue to hike, interest rates. Because bond prices and interest rates move in opposite directions, many bond investments stand to erode as rates keep ticking up.

But wait, you may be thinking, don't rising rates mean new bonds will pay more in interest? Yes, but rates are rising from absolute rock bottom. That same broad bond market index offers a yield of 2.6%. Compare that with the 8.3% inflation reading from April.

Even with these challenges, certain areas of the bond market can help shield your portfolio against swings in the stock market and protect your savings from inflation, says Eric Jacobson, a fixed income strategist at Morningstar. "A bond portfolio can act as a ballast against risks you're taking elsewhere because it's going to be less volatile," he says.

I bonds: 'The first place to start'

Many investors turn to bonds as a place to store money they're hoping to use for a short- to medium-term goal, such as the down payment on a home. Bonds, the thinking goes, are less likely than stocks to incur a large loss, and the interest they pay will help you keep up with inflation more than if you just kept the money in cash.

If you have a trove of money you want to use this way, U.S. Treasury Series I bonds (or just I bonds) currently represent a good option to research first, says Eric Jacobson, a fixed income strategist for Morningstar. "The first place to start is with I bonds," he told Grow. "They don't come with price volatility and you know exactly what you're getting if you turn them in early or hold onto them for longer."

These inflation-adjusted bonds pay a fixed interest rate throughout the life of the bond, plus a rate pegged to inflation. With the latest bump up in consumer prices, I bonds are currently paying a whopping 9.6% in interest — a number that will move up if inflation continues to rise, or down once it decelerates.

Because I bonds are issued by the U.S. government, which has never defaulted, you have virtually no risk of losing your principal. But there are a few catches. For one, you can't redeem these bonds for at least 12 months after you purchase them, meaning any money you don't plan on using in the next year doesn't belong in this investment.

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Cash out any time over the first five years of owning the bond, and you'll face a penalty equal to three months' worth of interest.

I bonds must be purchased directly from the Treasury's website, and you can buy no more than $10,000 worth per person per calendar year. You can purchase an additional $5,000 in I bonds using money from your tax refund if you file Form 8888, but it's too late to do so this year.

Use TIPS to keep up with inflation

Another way to keep up with inflation with fewer strings attached is with Treasury Inflation Protected Securities, or TIPS. These bonds are meant to provide inflation protection for folks who would otherwise hold Treasury bonds in their portfolio, while providing the same level of safety. (TIPS, like Treasurys and I bonds, are backed by the U.S. government.)

While Treasurys come with a fixed interest payment over the life of the bond, TIPS are indexed to the consumer price index and see an upward adjustment in value during periods of rising inflation, which in turn boosts your interest payments.

When calculating the benefits of holding TIPS, market-watchers look for the so-called "breakeven rate" between TIPS and Treasurys. Currently, the difference between the yield on a 5-year TIPS (-0.01%) and a 5-year Treasury (2.91%) stands at 2.92, meaning that inflation would have to average 2.92% over the next five years for TIPS to come out ahead of Treasurys.

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TIPS trade like most other bonds, meaning that you can hold them in an ETF, trade them any time, and hold them in any dollar amount. Be sure to your research, since that also means they're susceptible to the normal swings in the bond market, dictated by factors such as investor demand and shifting interest rates.

"TIPS are going to give you a guarantee that you'll keep up with the CPI over life of the bond," says Jacobson. "But that doesn't mean it won't experience interest rate volatility. If a regular 5-year Treasury is going to move up and down in price along with the bond market, the same is true of a TIPs bond."

Play defense with high-quality, short-term bonds

If you're looking avoid volatility, buying bonds that won't fluctuate too much in price may supersede the need to keep up with inflation.

"You can think of your bond allocation as a counterweight," says Jacobson. "And it should benefit when there is a flight to quality" — a term market pros use to describe investors piling into safe investments when riskier ones, such as stocks, get rocky.

To that end, if it's a stable counterbalance you seek, it's essential to focus on bonds that won't fluctuate much in value, even if they don't pay a huge interest rate, experts say. In today's market, that means focusing on two kids of risk in the bond market: default risk and interest rate risk.

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A bond defaults when the issuing entity, such as a government or business, is unable to pay its debts and the bondholders get stuck holding the bag. Credit ratings agencies assign the highest ratings to those issuers who are least likely to default (such as well-heeled firms and the U.S. government) and the lowest ratings to the riskiest deals. These days, you'd be wise to stick with the highly rated stuff, says Gargi Chaudhuri, head of iShares investment strategies for the Americas.

"Start looking at high quality parts of the fixed income market, which becomes important in this environment," she says. "These include the investment-grade credit and Treasury markets."

In general, longer-dated bonds are more sensitive to interest rates than their shorter-term counterparts. That means they'll decline more in price when interest rates go up. For the safest bet, stick with shorter-term bonds, which won't offer much in interest, but won't hurt your returns as much when the Fed hikes rates, says Chaudhuri.

The views expressed are generalized and may not be appropriate for all investors. The information contained in this article should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. There is no guarantee that past performance will recur or result in a positive outcome. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment decisions. No level of diversification or asset allocation can ensure profits or guarantee against losses.

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