Preparing for a stock market correction? We’ve got another thing to add to your to-do list: take a look at your fixed-income holdings, too.
Nobody knows for sure if an equity correction is imminent. But it has been nearly a decade since US stocks last posted negative returns. Since nothing goes up forever, and since corrections are historically common in equity markets, a downturn is certainly possible.
Normally, equities are negatively correlated with certain types of bonds—high-grade government bonds such as US Treasuries in particular. When equities fall in value, these bonds—we like to call them risk-mitigating bonds—usually rise. This is a big reason why bonds belong in a well-diversified investment portfolio.
But don’t make the mistake of thinking all bonds are alike. They’re not. High-yielding, return-seeking assets such as high-yield corporate bonds and bank loans are more closely correlated with equities than with other risk-mitigating bonds like Treasuries.
If you use bonds to balance out the risk in your overall asset allocation, make sure you have enough of the risk-mitigating sort. Otherwise, you may find that some of your fixed-income holdings magnify, rather than balance, your equity risk.
This is why investors shouldn’t leave the fixed-income component of their portfolios on auto-pilot. It’s always wise to keep track of changing conditions and how they might change your strategy. Stress-testing your bond portfolio can help determine if it’s properly positioned to reduce downside risk and to seize opportunities that can arise during market corrections. Here are a few things we think investors and their advisors should be doing:
1. STRESS-TEST YOUR PORTFOLIO AND REEXAMINE YOUR RISK TOLERANCE. Ask yourself how much overall risk you would want to take in your bond portfolio if equities fell by 5%. What about a 10% decline? And consider your time horizon. Figuring out what you’re comfortable with now will be easier than trying to do it on the fly when markets are more volatile.
2. MAINTAIN FLEXIBILITY BY AVOIDING THE MOST CROWDED TRADES. US stocks aren’t the only potentially overvalued assetin the market today. Central bank policies have forced investors to hunt for yield in many of the same places, and that’s pushed up prices—enough that in some sectors it’s doubtful that investors are being compensated for the risk they’re taking. Corporate debt markets, especially bank loans, are a good example. That doesn’t mean investors should abandon these sectors. But you may not want to be as overweight these sectors as you were 18 months ago, when yields were much higher. Be selective and make investment decisions based on value, not popularity. Should something happen that makes others want to sell, investors who didn’t follow the crowd may be in a position to buy attractive assets at a reduced price.