Can the bond market collapse?

What Happens During a Bond Market Crash?

When the bond market crashes, bond prices fall rapidly, just as stock prices significantly decline during a stock market crash. A bond market crash often results in rising interest rates.

Bonds are loans from investors to the bond issuer in exchange for interest earned. When the central bank raises interest rates, the price of bonds typically declines in the short term. Investors look at the interest payments on bonds, known as bond coupons, to determine how much they are willing to pay for the bonds.

When interest rates rise, investors can earn more money from newly issued bonds, so the price of existing bonds that pay lower interest rates falls. When interest rates rise rapidly, the price of bonds may fall quickly, leading to a crash.

Causes of a Bond Market Crash

A bond market crash can occur for several reasons, but two common causes are bond bubbles and central bank intervention.

Bond Bubbles: A bond market bubble occurs when bond prices rise significantly above their fundamental values for an extended period. The resulting crash is referred to as a bubble burst.

Central Bank Intervention: In a rising interest rate environment, existing bonds must trade at lower prices to compete with new bonds offering higher interest rates. Conversely, when the central bank lowers interest rates, bond prices rise because existing bonds pay a premium compared to new bonds.

How Does a Bond Market Crash Affect the Stock Market?

Theoretically, there is an inverse relationship between bond prices and stock prices in the short term.

When the stock market crashes, investors often turn to bonds, while a bond market crash typically leads investors to shift their money into stocks.

When interest rates rise rapidly, both bond prices and stock prices may decrease simultaneously. Bond prices fall in response to rising interest rates because investors can earn more money from newly issued bonds than from existing bonds. Rising interest rates also make borrowing more expensive for both consumers and businesses, impacting consumer spending and business activity, which in turn affects corporate profits and pulls stock prices down. Thus, both types of financial markets are affected.

What to Do During a Bond Market Crash?

When bond markets crash, it may provoke panic among investors, especially since bonds are supposed to be relatively low-risk investments. With falling bond prices, the value of your investment in a bond or bond fund decreases. However, selling bonds due to short-term price declines will leave you in a worse position in the long term. Also, remember that bonds are typically long-term investments that will continue to provide regular coupon payments. So don’t let short-term volatility affect you.

Just as you do with stocks, it is generally a good idea to diversify your bond portfolio. You shouldn’t wait for bond market fluctuations to do so. Diversification means spreading your money across different types of bonds with varying durations and investment profiles.

For example, U.S. Treasury bonds are less risky than corporate bonds. A good mix of short-, medium-, and long-term bonds can help mitigate some of the interest rate risks in your bond portfolio.

According to asset management firm AllianceBernstein, a good rule of thumb to keep in mind is that if the duration of your bond portfolio is shorter than your investment horizon, rising interest rates will benefit you no matter how high the rates go.

Additionally, if you anticipate rising interest rates, you can use investment strategies like bond ladders, which utilize bonds with different maturities to maintain a steady income stream while minimizing the impact of rising rates.

History

Bond Market Collapse

Bond market collapses often generate less interest than stock market crashes. However, they have occurred at several points in history. Here are some examples:

The Great Bond Market Catastrophe of 1994: In February 1994, the Federal Open Market Committee surprised investors by voting to increase the target federal funds rate by 25 basis points, the first increase in the target rate since 1989. The federal did not announce its intentions well and the announcement stunned the market, leading to a sell-off of bonds. As the bond market collapsed, the yield on 10-year Treasury bonds rose from over 5% in late 1993 to over 8% in late 1994. Bond investors, including banks and pension funds, suffered significant losses as a result.

The Taper Tantrum of 2013: Central banks such as the Federal Reserve often stimulate economic growth by purchasing U.S. government bonds and mortgage-backed securities, which reduces the supply available to investors. Bond prices rise and yields fall as a result. When the economy recovers, the Fed begins to taper these purchases in what is known as “tapering.” Tapering these purchases signals that the Fed is reducing economic stimulus and usually precedes raising interest rates. This leads to a surprising reaction in financial markets known as the “taper tantrum.”

The Bond Market Collapse of 2022: The Fed was forced to engage in buying again after the brief recession of 2020. It announced it would begin tapering purchases in November 2021. In the year that followed, rising inflation compelled the Fed to raise interest rates seven times. As a result, 2022 was a bad year for bond investors. The Bloomberg Barclays U.S. Aggregate Bond Index, which represents the majority of the U.S. investable bond market, fell by nearly 13% in 2022. Additionally, the S&P 500 – a benchmark for U.S. stocks – declined by 19.44% during the year.

Frequently Asked Questions (FAQs)

How can you profit from a bond market collapse?

As with a stock market crash, investors can profit from a bond market collapse by buying when prices are low and selling when the interest rate cycle reverses. When
Source: https://www.thebalancemoney.com/will-the-bond-market-crash-dont-bet-on-it-416940