Typically, bonds are considered safer than stocks during an economic downturn. 2008 was an anomaly, as concerns weren't about an economic downturn as much as they were about the entire system. Because of this, many investors opted to forego credit risk altogether and invest in U.S. Treasures. As a result, aside from Treasuries, most bond sectors saw sharp drops in value that were extremely unusual.
Equally as unusual are the rallies most bond sectors have staged through September of 2009 - they have been extremely sharp, in some cases more than recovering last year's losses. If the economy does hit a rough patch again, two factors will have a large impact on how bonds behave. The first factor is the riskiness of the business issuing the bonds, and second is inflation.
Porter Power
As to the former, we believe an investor should focus on higher credit quality businesses, and invest a smaller portion of a portfolio in high yield bonds. Within that high yield portion, we have focused our investments in the higher grades of high yield. Thus, while a downturn could adversely impact bond fund values, the impact should be a good deal less than that in the stock market. Regarding the risk of inflation, in a downturn in which wealth is decreasing and credit is constrained, it's hard to see inflation gaining a foothold in the near term. Thus, it's likely that low interest rates will be with us for some time, and bond values will not be impacted by rising rates over this period.
The bottom line is that bonds are likely to follow their historical tendency and be safer than stocks. One other key to weathering any potential downturn is ensuring that if you are taking money from your portfolio, you have set aside enough in cash and truly safe fixed income - Treasuries or CDs are what we use - to cover several years' worth of cash needs.