A few weeks ago I decided to build myself a tool to measure the risk in my portfolio. Nothing sophisticated, just a spreadsheet that would take my real positions and tell me how much I’d have lost in the great crises of the past had I gone through them with the portfolio I hold today. The first thing it handed back was one of those answers you’d rather not read, because they force you to reopen a belief you’d taken for granted. It told me that in a scenario like 2008 a substantial part of my bonds wouldn’t have protected me at all, and would in fact have sunk alongside the equities, in some cases worse.
There’s a very widespread idea, by now almost a mental reflex, that holding bonds in a portfolio is the same as having a safety net. The logic looks impeccable in its simplicity: equities are the risky part, bonds are the prudent part, so if I own bonds I’m doing the wise thing. The problem is that this logic really only works for one category of bonds, and you only have to move one square across to watch it turn completely upside down.
Do bonds really protect you if markets crash?
The honest answer is that it depends on the type of bond, and the difference is enormous. High-quality government bonds do genuinely defend you when markets crash. Risky corporate credit and emerging-market debt, by contrast, tend to fall apart alongside equities at exactly the moment you most need them to hold.
To understand why you have to remember how a bond’s yield is put together, because that’s where the whole story hides. What you collect is made of two distinct pieces. The first is the risk-free rate, which is what debt considered safe pays, such as that of a solid state. The second is the spread, the extra premium the market asks of you for taking on the risk that whoever issued that bond can’t pay you back. In a crisis these two pieces move in opposite directions, and understanding that movement is more or less all you need.
Why government bonds cushion crises (nearly always)
When panic breaks out, investors run towards what they perceive as safe. This phenomenon, known in the trade as flight to quality, raises demand for quality government bonds, pushes their yields down and consequently pushes their prices up. It’s why, in the classic crises driven by fear of recession, the government leg of a portfolio gains value while everything else suffers.
2008 is the textbook version of this behaviour. While global equities went on to lose around half their value from the peak, the yield on the US 10-year fell by more than a percentage point and a half, which means government bonds were rising in price precisely as equity markets burned wealth. That was real diversification, two components reacting in opposite ways to the same event.
It should be said, because reality is always messier than theory, that this mechanism occasionally jams. In March 2020, for about two weeks, US Treasuries were sold too, simply because in the most acute panic everyone needed immediate liquidity and was selling anything, even the safest asset on the planet. Then the central bank stepped in and the natural order returned. Those two weeks remain a valuable reminder, though, because no hedge is guaranteed one hundred per cent, and anyone describing one to you that way is selling you something.
Why emerging-market and high-yield bonds crash alongside equities
Here the picture flips entirely. For risky bonds, those of emerging countries or of companies with fragile balance sheets, the factor in charge is no longer the rate but the spread. And the spread, when a crisis arrives, doesn’t move elegantly. It explodes.
Again in 2008, the aggregate emerging-market debt spread went from around 200 to around 750 basis points, with some countries pushed beyond 900, while the spread on high-yield corporate bonds flew from around 500 to nearly 2,000 basis points. Translated into prices, we’re talking about violent losses, concentrated in exactly the same period as the equity crash. In practice these instruments behave far more like equities dressed up as bonds than like a real safety net. When you put them in a portfolio convinced you’re increasing your prudence, you’re actually adding a risk that is strongly correlated with what you already own, and you’re doing it in the very sleeve you believed was defensive.
2022, or when bonds and equities fell together
There is then one scenario capable of causing trouble even for the soundest government bonds, and it’s the one where the shock comes directly from rates. That is exactly what happened in 2022, and for many investors it was a surprise precisely because it contradicted instinct.
With inflation running and central banks forced to raise rates quickly, the yield on the US 10-year rose from around one and a half per cent to nearly four per cent within a few months. When rates rise that fast, bond prices fall because of duration, their sensitivity to rate movements, and meanwhile equities fall too, because a higher cost of money compresses valuations. The US aggregate bond index lost around thirteen per cent, the worst year in its history, and it was one of the worst ever for the classic balanced portfolio of sixty per cent equities and forty per cent bonds. The diversification that should have worked simply wasn’t there, and the two legs fell together, hand in hand.
The most interesting detail is that in a scenario like this the right defence isn’t buying protection on equities, as instinct would suggest, but reducing the duration of the bond sleeve. It’s a counterintuitive move that almost nobody connects to the scenario, and one that radically changes the outcome.
How to tell whether your bonds protect you or sink you
The good news is that answering this question about your own portfolio doesn’t require a doctorate in finance. It essentially takes three steps, and they can be done on a spreadsheet.
- Classify your bonds by their real category, distinguishing between quality government bonds, investment-grade corporates, high yield and emerging-market debt, because these are four different animals that react differently to the same event.
- Look at the duration of each, because that’s exactly what tells you how much you’ll suffer if rates suddenly rise.
- Simulate two opposite scenarios on the portfolio you hold today, a 2008-style credit crisis and a 2022-style rate shock, and watch what happens to the bond sleeve. If in the 2008 scenario that sleeve loses heavily, you have your answer, because it means it isn’t defensive at all. It’s risk disguised as prudence.
What comes out of this exercise isn’t a forecast, and that’s worth stating clearly. No tool will tell you when the next crisis is coming, and be wary of anyone who claims otherwise. What you get is something humbler and more useful: knowing precisely where the pain would come from if that crisis showed up, and being able to decide with a cool head, today, what you’d do in each case.
A closing thought
The thing that struck me most, at the end of all this work, wasn’t discovering that some of my bonds weren’t all that defensive. It was realising how long I’d sat comfortably on top of a belief I’d never actually checked. I had built a piece of my supposed safety on a single word, bonds, without ever stopping to ask which bond, inside which scenario, against which specific risk.
And at that point the suspicion widened, as it always does when you start pulling on a thread. How many other things do I take for granted, in my portfolio and probably outside it too, only because they sound prudent and make me feel safe? Perhaps the question that really matters isn’t whether we’re protected. It’s whether we know precisely what from.
