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What the Covid-19 shock teaches bond investors

What happened to the bond markets during the corona crisis? How will the markets develop and which lessons can investors learn? Dominique Maire, our Head of Fixed Income, explains.




Will investors ever look at bond markets the same way again? That’s a valid question after the Covid-19 pandemic sent a shudder of fear through markets in March 2020, causing them to freeze.

What happened on the bond markets during the COVID-19 crisis?
Bond markets were extraordinarily volatile during the corona crisis. Seen through the lens of emerging market and high yield ETFs, the higher risk end of the market, they fell by 20-25% from 19 February to the trough on March 23. That’s in line with the sort of volatility expected from equity markets. For the record, the US S&P 500 equity index fell by 33%.

“Fear takes over in a bad market,” explains Dominique Maire, Head of Fixed Income Investment Management at Julius Baer and a development economist by training. “These are over-the-counter markets that rely on people being willing to trade. In every moment of fear, capital commitment to trading is reduced because everyone has to manage their risk budget.”

Only those investors who sold when markets froze crystallised their paper losses. Some were forced sellers, as they had to raise cash to meet loan obligations or fund redemptions. Investors with holding power, on the other hand, had positive returns in US dollars over the first half of 2020, when broad and corporate US bond market indices delivered 6% and 5% returns, respectively. US high-yield market took longer to recover, but they also broke even by early August. 

This positive outcome would not have been possible without extraordinary policy action. Anxious that a liquidity shock could lead to a debt and financial crisis, the world’s major sovereign policymakers rightly opted for shock and awe. Taken together, they have injected a USD 9 trillion fiscal stimulus (source: IMF), more than USD 4 trillion of additional quantitative easing (QE) (source: Fitch) and a USD 8 trillion boost to the M2 money supply (source: JP Morgan). This swiftly restored confidence in the credit markets. It is also adding yet another thick layer of debt to the world’s balance sheet. 

What can investors learn from the crisis?
The number one lesson of the crisis is that bond investors should remain prepared for episodes of higher price volatility and lower trading liquidity. According to Maire, market shocks have historically offered opportunities to buy quality credit at attractive valuations. It’s also the right time for active portfolio management. “Adopt a sufficiently long investment horizon and stick to your strategic allocation and stay disciplined. Don’t buy when the knife is falling but when the policy reaction is clear. And last but not least, apply a quality portfolio construction process, with extensive risk diversification,” he says.

How will the bond markets develop post COVID-19?
Every economic cycle, and every time there’s an external shock such as the Covid-19 crisis, the world economy becomes more dependent on debt. The IMF calculates that total debt, including bonds and loans, reached USD 188trio or 226% of global GDP in 2018. The global bond market is worth more than USD 63 trillion today, judged by the capitalisation of the Bloomberg Barclays Global Aggregate Bond Index. It has doubled in the decade that followed the Great Financial Crisis (GFC), and grew by another USD 6 trillion year to date.

It also increased in scope for investors to diversify portfolios across issuers, which limits the downside risks (e.g. default risk). As the bond markets thus grew, policymakers had to closely monitor them, and the high level of debt forced them to embrace unconventional policy ideas. “There is an inducement for policymakers to allow for low funding costs so the level of debt remains sustainable,” explains Maire. 

Furthermore, he believes the corona crisis accelerated changes that were already underway. When looking at the global economy Maire cites lower growth and excess savings, regime polarisation in geopolitics and unconventional monetary policies in the policy realm. When looking at the behaviour of financial markets, he lists the demand for growth and yielding assets. 

Overall, he is optimistic about the market outlook. “The speed and amount of fiscal stimulus and QE together with the increase in the balance sheet and the resulting liquidity boost has been remarkable. Central banks have suppressed bond market volatility and provided accommodative guidance. This is a tail wind for credit markets. Why? Excess money supply boosts savings and thus the demand for yielding assets. At current interest rates, most high quality government bonds may yield low or negative returns. Corporate bonds represent attractive alternatives, thanks to their predictable cash flows. Even so, default rates will rise in the countries and sectors most exposed to the Covid-19 shock. “Governments and central banks will not be able to save everybody,” says Maire.

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