Bear market investing

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9. Bonds

Investors nervous about the prospects for stocks in a bear market may well find it pays to take refuge in bonds. Not only will you have the comforts of relative certainty and safety but you also have the prospect of tax-free capital gains if the value of the bonds rises (or losses if it falls).

First - a reminder of what bonds are:

Essentially they are IOUs. Governments and companies use them as a way of raising money. As an owner of bonds, you receive:

• a fixed rate of interest (also known as the coupon)
• repayment of capital at a future specified date (the maturity date)

The rate of interest you get depends on the risk rating of the issuer. Government bonds of the major Western economies ('gilts' in the UK), are considered the safest, then corporate bonds issued by blue chips, and at the bottom come 'junk' or high-yield corporate bonds, and government bonds of less financially-stable countries.

Compared with shares, bonds have some advantages and some disadvantages. On the plus side, your income is certain, your money is generally safe, and liquidity is good. On the minus side, the rate of interest you get may fail to keep pace with inflation, the upside potential is not as good as stocks, and historically bonds have not performed as well as stocks over the long term.

In a bear market, the virtues of certainty and safety may outstrip the disadvantages, but, as with shares, the price you pay is important. If you plan to hold your bonds to maturity, there is no problem: you will get your capital back. But if you plan to sell them before maturity, the price you get will be what the market is willing to pay at the time. And bonds can be just as volatile as stocks. In general:

• Bond prices rise when interest rates go down, and fall when they go up
• Bond prices rise when inflation goes down, and fall when inflation goes up

Since, in bear markets one expects falling interest rates, one also expects rising bond prices. But choose your bonds with care. Like stocks, risk and reward go hand in hand.

• Cautious investors may consider sticking to government bonds with a repayment date between two and five years out. These have a low risk of default, fairly low price volatility and can be bought easily through brokers.
• Corporate bonds, even if held in collective investments such as unit trusts, are much riskier than government bonds, especially in difficult economic times, because there are increased risks that the issuing companies may default.
• Thinks hard about whether you intend to hold the bond to maturity. If you don't, be aware that you face a potential capital loss if you sell it early.
• Consider your tax position. Low coupon bonds roll up more of their return in the form of capital gain. As capital gains on gilts are tax-free, these are better for higher rate taxpayers.
• Remember that bonds experience their own bear markets: with every point rise in inflation and interest rates, bonds lose their value.
• Bull markets in bonds usually end some time before bear markets in shares have run their course.

1. A word on bears 2. What is a bear market? 3. Why do bear markets happen? 4. How to spot the appearance of a bear market 5. How bear markets end 6. Bear market investment options: timing the market 7. Bear market investment options: the asset classes 8. Stocks: blue chips vs small caps 9. Bonds 10. Property and gold 11. Cash 12. Stocks: general principles 13. Bear-proofing - low 'beta' stocks 14. Bear-proofing - high yield shares 15. Bear-proofing - sectors that historically do well in bear markets 16. Bear-proofing - sectors that historically do badly in bear markets 17. Bear-proofing - key ratios for selecting stocks 18. Bear-proofing - investing in stocks you know and can support 19. Bear-proofing - pound cost averaging 20. Recognising the revival - a check list 21. Conclusion

• The Bear Book
• Stan Weinstein's Secrets for Profiting in Bull and Bear Markets
• The Great Crash, 1929