Maximizing Portfolio Stability: The Role of Core Bonds in Recession Protection

Those attractive yields are good for another major bond win: recession protection.

While a soft landing is still in the cards, the potential for a near-term recession or even one further down the road is still there. And bonds’ current higher yields make them compelling bear market and downturn fighters. For investors, it’s another reason to add core fixed income to their portfolios.

It’s old hat at this point, but the Federal Reserve’s tinkering on interest rates has allowed bonds to yield more than they have in over a decade. This includes so-called core bonds. Core bonds are the bread & butter of the sector and represent investment-grade issuers. This includes Treasury securities, corporate bonds, and agency-backed bonds like Fannie Mae mortgage securities. Municipal bonds aren’t included in core bonds due to their tax-free nature despite many having features of investment-grade debt. Typically, core bonds are those in the intermediate maturity band of about five to 10 years.

The sector benchmark—the Bloomberg U.S. Aggregate Bond Index (Agg)—is technically a core bond index. And right now, core bonds are paying some good yields.

The nearly 12,000 bonds in the Agg—as represented by the iShares Core U.S. Aggregate Bond ETF—are paying 4.63%. That’s not too shabby at all, especially considering that the index was yielding less than 2% a few years ago.

The Fed’s role in boosting interest rates to cure inflationary woes and slow the economy has pushed down bond prices while subsequently boosting the yields on already issued bonds and newly issued ones. For investors looking at yield, it’s manna from heaven.

It turns out that higher starting yield isn’t just good for our wallets and income generation. It’s also great for placing bonds back into their role as a volatility dampener for portfolios, particularly during recessions.

While the Fed may pause for a while longer, rate hikes are almost certainly off the table. Dwindling economic data and a lowered inflationary picture has made sure of that. This is wonderful news for investors. Bonds have settled into their pricing, with their volatility coming down. Looking at the Agg, the index is in roughly the same place as it was at the beginning of 2023.

It’s the yield that is driving returns.

This is how bonds work well during recessions. Remember, investors get their principal back when a bond matures. This provides a safety net. That safety net is stronger with core bonds due to their investment-grade nature. There’s almost no chance of a default from the federal government and only a very small chance from an issuer like Microsoft.

However, that doesn’t mean investors don’t sell bonds during downturns. But when yields are plentiful, there’s less reason to sell. That’s the case today. Why sell when you can get a 4%+ yield and still have the safety of principal?

Data backs this up. In every recession since 1950, bonds have delivered higher returns than stocks and cash. Looking at the modern era—post 1970 and the shift from the gold standard—drawdowns for bonds have been much less than stocks. Looking at the seven recessions since 1972, U.S. core bonds have had an average recession maximum drawdown of 3.6% and it’s taken them about 10 months to recover. Equities? We’re looking at an average drawdown of about 38.4% and a recovery time of 44 months. ¹

This chart from MFS compares the two asset classes during recessions (the gray bands).

Source: MFS

We have to give credit where credit is due. The Fed has done a pretty good job of navigating the interest rate environment and slowing inflation. The so-called soft landing that the central bank wants to achieve may actually happen. Historically, though, the Fed has been the major factor to cause a recession, pushing rates too high for too long.

And we’re starting to see some economic data dwindle. Consumer spending is down, job growth has slowed, business spending and manufacturing are lower. Housing is still a mess, etc. We can’t 100% rule out a recession today and we certainly can’t rule one out in the future.

With their high current yields, investors can lock in recession prevention in their portfolios with core fixed income assets today. Luckily, adding core bonds is a snap, both individually and through ETFs and funds.

Treasury bonds and investment-grade corporate bonds have a very liquid tertiary and secondary market. Moreover, the vast bulk of bond funds cover these bonds. Investors may want to look toward active management to score better yields and potential values.

These ETFs were selected based on their low-cost exposure to core bonds, Treasuries, investment-grade corporate bonds, and mortgage-backed securities. They are sorted by their YTD total return, which ranges from -0.5% to 0.6%. They have expense ratios between 0.03% and 0.36% and assets under management between $55M and $314B. They are currently yielding between 3.6% and 4.8%.

For investors, bonds’ higher yields are not only good for income generation, but in helping reduce recessionary risks. Overall, the higher yields reduce the need for selling and provide lower volatility for portfolios. That provides a base for when times get tough.

In the end, bond yields are back to normal. That’s wonderful news for investors seeking recession protection. Bonds now offer a big margin of safety when it comes to drawdowns and mitigating recessionary risks. Core bonds offer a great opportunity to add that protection today. Doing so via individual bonds or ETFs is a smart idea.

¹ MFS (November 2023). Fixed Income Investing in US Recessions