Bonds and Bond Proxies for Capital Preservation and Hedging Against Market CRashes

At some point, we are going to be in the midst of the next recession or the next financial crisis. Once resolved, there will be another recession at some point after. Bonds (and bond proxies) provide reduced volatility and capital preservation on a portfolio. 

During market busts we often see a ‘rotation’ into ‘safe haven’ assets (bonds) from risk assets (equities) so owning bonds is a way of hedging against market crashes and pullbacks.

Reasons to Own Bonds

"They are still the best hedge against stock market volatility"

At the time of writing (2024), for the first time in a few years, bonds are acting again as a hedge against stock market drawdowns. Or in other words: after a period of positive correlation which wrecked 60/40 portfolios, the stock/bond correlation is turning negative again.

The chart below shows the 6-month (120 trading days) correlation between the S&P500 and 10-year Treasury future prices.

The correlation was negative for most of the last 15 years: this means investors could count on bonds acting as a diversifier during periods of equity drawdowns. But as you can see from the chart, this wasn’t always the case: for most of the ‘80s and ‘90s bonds and stocks were doing pretty much the same thing at the same time – they were positively correlated. The same happened in 2022-2023 as inflation was out of control.

CASE STUDY: THE 2020 COVID PANIC CRASH

Take the Coronavirus inspired flash crash of 2020. Here are the returns for the Vanguard Total Stock Market ETF and the Vanguard Total Bond Market ETF from the stock market peak in February 2020 to the bottom in March 2020…

Central Bank Interest Rates and Financial Crisises

For decades now the Fed (biggest central bank in the world) argued that it should keep interest rates at zero… and continue printing hundreds of billions of dollars, because it wanted inflation to hit “2%.”

This is why the Fed did what it did after the Tech Crash, the Housing Crash, and the COVID Crash. Anytime someone pointed out that the Fed’s monetary policies were creating another, even larger bubble, the Fed told us, “We need to keep doing what we’re doing until inflation hits 2%!”

But, how can you create inflation of 2%, and make sure it stays at 2%? Inflation isn’t like a car where you can hit the desired speed and then press “cruise control.” Regardless, the Fed spent well over $7 trillion pursuing this goal in 2022 and when inflation arrived, it’s clear the Fed had no idea what it was doing. Official inflation numbers were likely a lot lower than 'real' inflation. 

The Fed then claimed it needed to tighten monetary conditions to stop the very inflation it created. Stopping inflation means the Fed needed to raise rates. But the world is awash in debt and quite a bit of it was issued based on rates being at EXTRAORDINARY lows.

Some $2 trillion in corporate debt was issued in the U.S. in 2021. The U.S. Government issued another $5+ trillion. So right off the bat, you’ve got $7+ trillion in debt that was issued while rates were effectively at zero.

How is this going to adjust to rates at 1%? 2%? Higher?

For bonds with yields this low, every time the Fed raises rates, there is a dramatic impact. Remember, the yield on U.S. Treasuries represent the “risk free” rate of return against which the entire financial system is valued.

So, when the Fed raises rates, that $7+ trillion must adjust accordingly. This means those bond prices FALL and their yields RISE. And if they rise enough, the investors begin to default.

Globally there is $30+ TRILLION MORE DEBT with sub -2% yields than there was the last time the Fed attempted to raise rates.

How is all that debt going to handle higher rates? What if the Fed has to raise rates way over 2% to stop inflation? What happens to the mountain of debt that was created based on yields being at 0%?

If you think the Fed can navigate this successfully, I would like to point out that the Fed wasn’t able to deflate the Tech Bubble nor the Housing Bubble without creating full-scale crises.

What are the odds the Fed can successfully deflate this current Everything Bubble… which is exponentially larger than the first two?

It is for these very reasons that we need to remain highly vigilant to thsi problem in order to protect our long-term savings and retirement pots...

Not all Bonds are created equal

In the Great Financial Crash 2008, Certain types of bonds faired much better than others...

• Sterling gilts (+18%)

• Global treasury (+14%)

• Global aggregate bonds (+10%)

• Global high yield bonds(-37%)

• Global equities (-37%)

• Equity Income (-47%)

• Global REITs (-56%)

You may be surprised to learn that Bond prices can be quite volatile. But that’s not necessarily a bad outcome for your portfolio. Consider the following examples:

• 12% Return in 2008 – In June 2007, the 10-Year US Treasury yield stood at 5%. Over the following 18 months, the S&P 500 lost almost 40%. Yet, US Bonds returned 12%.

• 34% Return between 2000 and 2003 – During the Dot Com crash, 10-Year Treasuries returned 34% over 3 years, while their starting annual yield was only 6.5%. 

Only the 3 bond classes in green below delivered the shelter needed from the Great Financial Crash 2008.
(Figures are for OCT 07 to MAR 09). As can be seen below, high-yield bonds are highly correlated with equities

In a deflationary bust such as 2008 we would see the chart below rise to and exceed the 300 weekly MA. At the time of writing in early 2025 we are nowhere near. Not predicting the future here but we should track the big picture before making decisions ahead of time.

Does Bond Duration Affect Capital Protection?

In short, yes. Whilst long duration bonds 20Y to 30Y may still hold their own in a downturn, it's the intermediate to short term bonds that work best in these conditions as can be see by the chart below for bond performance in the GFC 2008. In the 2005-2009 chart segment where the 2, 5, and 10 year UK Gilts are seen to rise more than the 30 year during the Great Financial Crisis. An Intermediate bond fund/ETF may be optimal: -

Bond ETF Trend up Whilst the SP500 Trends Down?

If you start seeing the price action of the SP500 drop below the key daily and weekly moving averages and start using them as resistance instead of support, whilst at the same time you see the Medium term bond ETF's such as TLT and IEF trend up, it's a sign that rotation into bonds is occurring due to a secular decline in stocks.

The GFC 2008 crash in the chart below shows weekly MA’s starting to act as resistance rather than support. The inset chart shows the 2 big bond ETF’s TLT and IEF starting to outperform the SP500 when this happens. This is one of the major market warning signs that something serious is happening in the stock market. So, whilst the SP500 lost about 60%, these ETF’s GAINED about 30%. But, the GFC 2008 was a deflationary induced crash hence the outperformance of bonds. An inflationary crash would also see bonds crash as well as stocks as was seen in 2022  

Vanguard Global Bond Funds vs IShares Global Bonds Fund

The two Vanguard funds below are the two big globally diversified 'aggregate' bond funds on the Vanguard UK platform. Aggregate bond funds invest in a mix of government and corporate bonds. The third fund linked to below  (the iShares fund), is a high quality globally diversified fund holding government bonds only from 7 major countries (the USA, Japan, France, Italy, Germany, the UK, and Canada) and tracks the Bloomberg Barclays Global Aggregate Government Bond Index.

If we go by past performance, the aggregate bond funds should do better than the iShares Gov bond funds when markets are on the up but the iShares fund should perform (possibly significantly) better in a financial crash scenario. For example, during the Coronavirus crash in 2020, global equity markets plunged 26%, VAGP below went down 3.15%, but the iShares fund (IGLH) rose 1.4%

• Vanguard Global Aggregate Bond UCITS ETF (OCF: 0.10%) (Income version: VAGP / Accumulation version: VAGS)

• Vanguard Global Bond Index Fund (VANGRSA) (OCF: 0.15%)

• iShares Global Government Bond UCITS ETF (IGLH) 

Vanguard vs iShares

One of the biggest rivals in the UK to the Vanguard global aggregate fund in terms of ETF size is the iShares AGGU Aggregate Bond ETF which tracks the same aggregate bond Index as the Vanguard ETF. The main difference is that the Vanguard ETF is GBP Hedged whereas the iShares ETF is USD Hedged. At the time of writing, in GBP terms, the Vanguard fund is up over 4% YoY, whereas the iShares ETF is down about 2% in GBP terms. If you're in the UK, you are going to opt for the Vanguard ETF more than likely. The fees (OCF/TER) for both ETF's are just 0.1%.

Global Government vs UK Gov

If you opt for UK Gov Bonds over the iShares Global Gov Bond fund above, the Vanguard VGVA UK Gilts ETF is a snip at 0.07% (OCF/TER). With UK Gilts being the best performing asset class during the GFC 2008 crash I personally might consider mixing VGVA and IGLH together betting on a similar flight to safety for UK Gilts in such a crisis.

VGVA is simply the 'accumulation' version of the same Income version of this ETF... "VGOV" which is mentioned further below in this article.  

Vanguard vs Vanguard

When you add up the 'actual' total cost of ownership (TER + underlying transaction costs) for the two Vanguard funds, there is hardly anything in it. The maturities, duration and credit quality are the same also. They are both over £1Billion AUM. For these reasons either fund should perform the same job.

The ETF fund now offers an 'accumulation' version as well an 'income' version which is on par with the Index fund. So either fund offers more convenience as you don't need to worry about reinvesting the income pay outs (if you don't want/need the income), it's done automatically for you. By that token, you also get an instant compounding effect from the instant reinvestment of income which might make a difference depending on how much you have invested in the fund. 

The only actual difference between the Index fund and the ETF is that the ETF has about 10K bonds whereas the Index fund invests in around 14K bonds. So the extra 4K bonds would explain the slight additional cost (see OCF above) but this won't make any difference to investor returns or protection.

Using These Bond Funds as a Hedge in a Global Financial Crisis

As stated above, it was only global government bonds that made gains during the Great Financial Crisis 2008. Should a similar situation occur in the future, personally, I would be seeking shelter in one of these funds and if a GFC style crisis it would the iShares government only fund (IGLH). 

There is actually another iShares Global Bond fund (SGLO) which invests in the same countries as IGLH but managed to out-perform it's peers significantly during the Covid Crash (see below). I haven't quite figured out why yet, but will be writing a post (or adding a video to the BBI YouTube channel) once I have figured it out.

SGLO below is the orange line on the chart and what you are looking at is the 2020 Covid Crash where the SP500 (the green/red line) crashed , whilst SGLO made some impressive gains (as you can see in the chart) initially during the "peak fear" sell-off, but then suffered it's own slight decline before stabilising. It was at this point the SP500  started catching up after central bank intervention.

The cyan line is the iShares (IGLH) government bond, and the yellow line is the Vanguard fund mentioned above. These also rose somewhat initially and then, whilst SGLO was surging, suffered their own declines. However, as you can see in the chart all of these bond funds eventually converged to the same level whilst the SP500 surged above them all... 

Looking at the chart, the optimal investment path would have been to allocate/rotate to SGLO at the start of it's rise is the 'rising fear' stage, and then selling out once seeing the 'hockey stick' irrational peak, back into the SP500. If we did see another similar 'extreme fear' situation in the future I will be considering the above. This might be another pandemic, but might also include a serious war between China and Taiwan where the US gets involved, or something of that magnitude. Nuclear war of some form is probably the worst example where SGLO could be a good bet.

US/UK Bonds Home Bias

A popular alternative for readers in North America on the US Vanguard platform is the Vanguard Total Bond Fund which is made up of roughly 65% U.S. government bonds. (This fund is often recommended by certified financial advisors in the US)

• Vanguard Total Bond Fund (BND)

This large allocation to the US provides a 'home bias' for US investors whilst still delivering global diversification. Standard advice these days usually recommends a globally diversified bond fund to spread the risk amongst currencies and countries.

Investors in the UK who opt for 'home bias' in their bond allocation might split between one of the aggregate funds above and VGOV below. (Note: These funds will already have an allocation to VGOV on the Vanguard platform)

• Vanguard UK Gilt ETF (VGOV)
  
  

Personally, I would rather just spread the risk, so I just invest in the VAGS Global Bond fund linked to above.

Standard advice is... "Don’t pay too much attention to the ‘Yield Curve’", but...

The ‘yield curve’ is the difference between interest rates on long-term versus short-term bonds. Long-term bonds pay higher rates of interest. A yield curve is said to be ‘inverted’ when long-term bonds are paying lower rates of interest than shorter-term bonds. It doesn’t happen often and the reasons are complex… way beyond this article.

 When it does happen, the logical reaction is to invest in shorter-term bonds… you get equivalent, or even slightly more interest, without tying up your money in longer-term bonds.

Also, when stocks plunge, the initially “rush to safety” usually sees fund flows into investment-grade bonds (especially Treasuries) so short-term bonds and their prices, rise.

However, this scenario often sees central banks then lowering interest rates (to kick-start the economy), which lifts longer-term bond prices. So, even in this scenario, longer-term Treasuries/bonds are still a good hedge against stock market falls. And even when the stocks are soaring, sometimes, interest rates will still fall, in which case holding long-term bonds makes sense.

For these reasons an ‘aggregate’ bond fund (or a globally diversified bond fund) that invests in a mix of government and corporate bonds and maturity dates is a common 'default' for many investors.

The big caveat to the above was seen in 2022 when inflation spiked and central bank rates and therefore bond yields spiked leading to big falls in bond funds. This really showed that bond funds... and bond fund will suffer when inflation gets over a threshold which is roughly about 3.5% to 4%.

The narrative surrounding inflation before the spike was that the spike was likely to occurr. It is these kinds of warnings that we are looking out for and informing investors about on Boom Bust Invest.

Reasons NOT to own Bonds

Despite all of the above, bonds are facing headwinds. The threat of rising inflation that sticks around is real, as is the possibility of rising interest rates. This inflation risk is the main reason some prefer inflation-linked bonds such as the UK Gilt fund linked to above. In the US, an equivalent would be an ‘inflation-protected’  US Treasuries (TIPS) fund. However, in the 2022 high inflation downturn, the inflation-linked bonds offered no protection whatsoever!

Long term inflation is the nightmare scenario for bonds. The last time there was a real problem with inflation in the 70’s (before the 2022 crash), 10 year Bonds/treasuries nose-dived then also. 

The Effect of High Inflation on Bonds and Bond Funds

I recently took some measurements on bond fund price crashes on the Vanguard UK platform sparked by the spike in inflation during 2022. Now, it should be said that the circumstances that caused these bond fund devaluations were highly unusual as they were ultimately caused by the high inflation after Covid with all of the government fiscal stimulus as well as the central bank money printing, but it goes to show what can happen to bond funds uner these extreme conditions: -

U.K. Inflation-Linked Gilt Index Fund: -24 %

U.K. Gilt UCITS ETF (VGOV): -18.5 %

U.K. Government Bond Index Fund: -18 %

Global Bond Index Fund: -10%

Global Aggregate Bond UCITS ETF (VAGP): -11 %

Life Strategy 20 (80% bond fund) Fund: -11 %

U.S. Government Bond Index Fund: -9 %

As expected, the Government Bond fund offered the most protection, but not materially so when compared to the 2 global funds. The Life Strategy 20% equities 80% bond fund was also on a par with the global funds and it is mostly a global bond fund which makes sense, but it's interesting that the 20% allocation to global equities didn't make much of a difference in terms of overall protection so if you were in the Life Strategy 100% equity fund you could have switched to the 20% fund quite easily to seek shelter.

Bond Ladders in an Inflationary Environment

During an inflationary environment interest rates are going up. Short duration government bonds of three to six months will have high interest rates and as those bonds mature you can just keep buying new bonds with set future maturities (laddering). If the inflation and interest rates continue up as you 'ladder' then you keep getting a higher and higher interest rate so your interest income is continually growing. This would be favourable in comparison to stocks which probably wouldn't be doing well in a high inflation environment.

You can buy UK Government Gilt bonds on the UK Debt Management Office website.

The great thing about bonds is that as those bonds mature, you get all your money back and can invest again. The advantage of owning the individual bonds as opposed to investing in a bond fund is that if interest rates go up, the price of your bond will be go down (as will the price of a bond fund), but when the bonds mature, you are guaranteed to get all your money back. With a bond fund, if you sell when the price is deflated by high interest rates you will lose money.

Bond Ladders as an Alternative to Annuities

In the UK, Annuity providers simply buy inflation-linked government bonds (called 'Gilts' in the UK). So It is possible to DIY this and simply buy UK government bonds of increasing maturity and, take the guaranteed 'coupon' payments as income along the way, and then simply reinvest the maturing capital each time a bond reaches maturity...

... this avoids the high fees, at least in the UK, that are charged by insurance companies who sell annuities.

Bond Proxies vs Bonds?

A diversified approach to capital preservation might be to own some standard bond funds, and then additionally, owning bond-like (bond-proxy) multi-asset funds below.

When rates and bond yields are low, income focussed investors (such as older investors focusing on income in drawdown) might be pushed into high-quality equities. High-quality companies with consistent earnings growth and margins and a history of dividend increases have gained in popularity over buying bonds at the top of a 3-decade long bond bull market with ever lowering interest rates.

They are sometimes called “bond proxies”. In the UK, Unilever, Diageo, Halma and other similar stocks have all done very well out of this trend. In the US, the same applies to the likes of Coca Cola and other behemoths that comprise large parts of Warren Buffet's Berkshire Hathaway fund.

However, they face one major threat. They have benefited from low interest rates, as that has forced income investors of all sizes to use them as a proxy for bonds. If rates rise and such investors can once again achieve super safe yields of 4% or 5% yield from government bonds, then we will likely see a rotation out of these bond proxy stocks and back into bonds.

When interest rates are low, this alternative to bonds are an option (or bond like diversifier) for steady income along with probable share price inflation, but when rates rise, DIY investors who own these shares may look to rotate back into bonds.

'Multi-Asset' and 'Total Return' Funds as Diversified Bond Proxies

As an alternative (or addition) to the bond only funds above, investors have turned to ‘bond-like’ funds classed as multi-asset (a.k.a. "total return" or "absolute return") funds. These funds invest in a mix of stocks, bonds, commodities and other assets to provide capital preservation on the down-side and hopefully still some growth on the up-side. These funds are explained further on the Capital Preservation Portfolio page

What is your strategy for Bonds & Bond Proxies?…

Clearly, bonds hedge against stock market downturns but over the longer term the return from bonds is still lower than equities. My personal view is to hold bonds when there is a real problem in the financial markets making a 'rotation' from equities to bonds more likely.

The alternative is to hold a percentage of bonds (20% / 30% / 40%) indefinitely in a portfolio and accept lower longer term gains for the sake of lower volatility.

For example, when the S&P 500 Index was down by over 20% between February and March 2020, the 10-year Treasury note (bond) was up 8%. In the Great Financial Crisis 2008 the main saviour for many portfolios were their bond allocations.

"Bonds can be used to buy stocks… to rebalance"

As shown above, a stock market sell-off can increase the valuation of bonds. But when the equities bust turns to boom you need the funds to buy the discounted stocks. Selling bonds then is a good option to fund your purchase of cut price equities.

So just maintaining a set portfolio bond allocation (e.g. 40%) periodically in a declining equities market will mean you are selling bonds (which have gone up in value) to buy equities (which have gone down in value).

Bonds are still THE diversifier of choice

Bonds perform differently from shares and other alternatives, so when uncertainty is the dominant narrative, owning bonds make sense to cushion the blow when non-bond investments fall. There is a reason bonds are still the go-to asset class for diversification. They are not the only game in town, but they are the longest-running game in town, which counts for a lot.

Bonds are still THE diversifier of choice... BUT...

Corporate bonds are correlated with stocks so they don’t necessarily provide diversification from equities. Also, if we are using bonds as a tactical protection investment in a financial crisis (see below) then the Ishares Gov bond is a decent bet. The Vanguard bond fund mentioned above, contains Gov and Corp bonds and won't provide as much protection as the Gov bond only fund. In a financial crisis scenario I certainly wouldn't want to be invested in only corporate bonds such as Vanguards Corp bond fund.

Bonds provide stability when you might need it most

If you have living expenses or a large purchase that you need to make, it could be hard to stomach selling some of your stocks at the bottom of a stock market crash. Bonds provide that stability and funding power during a crash when you could need it the most.

Bonds protect against deflation

One of the biggest risks to bonds is inflation. It devalues the fixed interest you earn and the longer-dated bonds carry more of this inflation risk. Inflation leads to a hikes in interest rates which triggers declines in bond prices. The biggest recent example of this occurred in 2022 on a global scale. 

But, even in this worst case scenario for bonds, central banks act in unison to bring inflation under control and also people may simply reject higher prices. This could lead to outright deflation. In this scenario, your bond income is worth more over time. This is another reason why bonds tend to do well during a recession.

Even if interest rates do go up leading to bond price falls, you still get the interest payments which can then be re-invested. The interest on bonds is also called the ‘coupon’.  It is argued that this helps to cushion the blow for falling bond prices because if interest rates on bonds are also rising then this re-investment effect is amplified. This reduces the argument to wait for interest rates to fall before investing in bonds, however 2022 proved that you still would prefer to time your entry into and out of bonds when inflation spikes and the returns to normal.