Bonds are a good investment before a financial crisis but not necessarily during one. Whenever the market dips significantly, it triggers what financial people call a "flight to quality." It might just as well be called a flight to safety. That is, investors dump risky stock and buy up bonds and so-called blue-chip stocks, which historically have retained their value over time. In the financial world, Treasury bonds and notes are considered risk free.
Timing the Market
When investors are competing to buy bonds, bond prices go up and bond yields fall. Thus, the trick is to buy before the crisis, not during or after it. Knowing when to change investment strategies is partly art and mostly sentiment -- optimistic or otherwise. In June 2007 the stock market was still strong because of high housing prices and high-risk derivatives based on subprime mortgages, but financial experts knew a storm was coming. The subprime mortgage market was losing steam.
Inflation Raises Bond Yields
The chief factor in bond pricing, however, is inflation, which muddies the impact of investors' anxieties on the bond market. In 2007, inflation rose to 4.1 percent from 2.5 in 2006. In June 2007, the yield on 10-year Treasury notes, which are short-term bonds, rose to 5.36 percent from 4.68 percent in January. This was a good time to buy bonds. When the Dow Jones Industrial Average and the Standard & Poor's 500 Index hit their peaks in October 2008, 30-year Treasury bonds reached 4.9 percent. This, again, was a good time to buy bonds.
When to Sell Bonds
Bonds can be a great relief to an investor when a crisis strikes the stock market. You won't lose money. You may forgo higher returns you might have realized if you had successfully invested elsewhere. Still, you would have felt like a genius if you were holding bonds instead of stock in October 2008. That month, the Standard & Poor's 500 index began a short, sharp slide to 683 in March, losing about 60 percent of its value. If you had switched from stocks to bonds in December 2008 and held them, your returns five years later would be modest -- some 2.25 to 3.22 percent -- but higher than inflation.
See, Think, Act
Since 2008, the Federal Reserve has kept interest rates low, making bonds a lackluster investment, while the Dow Jones and the S&P; 500 have set record highs. In hindsight, investors can see that buying bonds in mid-2008 and returning to stocks in late 2009 would have been the ideal path through the crisis. But managing investments, like the governmental measures that prevented a second Great Depression in late 2008, requires strong strategic insight and a willingness to act. Unfortunately, many investors lack one, the other, or both.
- Federal Reserve Bank of St. Louis: Economic Research -- Dow Jones Industrial Average
- Bloomberg News: Fed Laughs Peaked in June 2007 Before Crisis Hit; Jeff Kearns and Aki Ito
- Treasury.gov: Daily Treasury Yield Curve Rates
- US Inflation Calculator: Current U.S. Inflation Rates, 2003-2014
- Fed Prime Rate: Standard & Poor's 500 Index History
- Photodisc/Photodisc/Getty Images