How to Survive a Recession

LESSON 18: Sell Stocks and Buy Bonds

Common stocks and bonds are inherently different investments. The beginning of an economic recession is the ideal time to buy investment-grade bonds issued by large corporate borrowers and governments.

There are three reasons to sell stocks and buy bonds at the beginning of a recession:

Equities (stocks) are a leading indicator. As investors begin to reduce their corporate earnings expectations, stock markets correct downwards at a rapid pace in anticipation of further drops in earnings. Institutional investors sell stocks quickly and buy something with better profit potential and less risk. Stocks will therefore lead on the downside going into a recession.

Existing high quality bonds go up in price. Investment-grade bonds have predictable cash flows. Falling interest rates make existing bonds paying higher interest more attractive. As equities begin to drop, major institutional investors buy investment-grade corporate, treasury, and municipal debt that will pay them predictable cash flows with reduced risk of loss. The key here is “investment-grade”, not junk bonds or convertible bonds. As long as the bond issuer (company or government) is in good financial shape there is little likelihood that it will default on its bonds.

As interest rates drop, outstanding bonds paying higher interest become attractive to institutional investors, who borrow capital at the new lower rates and purchase previously-issued debt to earn the spread in interest income above interest payments. Since the big players drive the markets, you should imitate them by selling equities and buying investment-grade bonds.

You should buy bonds at the beginning of a recession, not the end. As the economy comes out of recession, you should shift your investments out of bonds and back into equities. Interest rates stop dropping, there are fewer high quality bonds that have not matured, and bond prices have already been bid up so their yields are low. If you wish to remain invested in fixed income, moving money from investment-grade to high-yield bonds, junk bonds, and convertible bonds will generally provide a better reward-to-risk ratio toward the end of a recession.

SPECIAL NOTE ON MBS AND ABS:

Mortgage-backed and asset-backed securities are not corporate or government bonds and are not the ideal investments at the beginning of a recessionary cycle. When a recession hits mortgage and credit card defaults increase significantly, which undermines the cash flows of the MBS or ABS bond. In comparison, investment-grade corporate and government bonds are simpler instruments and do not have the additional correlation risks inherent in securitized pools of assets. These MBS and ABS pools have complex dynamics and tend to do poorly when a recession strikes. The credit crisis that began in 2007 was kicked off by these dynamics, combined with bad "investment-grade" ratings and over-leveraging of MBS and ABS portfolios.

The lesson here is this: stock to simple investment-grade corporate and government bonds during recessions.