During a recession, government bonds are likely to outperform other classes of investments. This is because during a recession, investors tend to move their investments to safer assets, and government bonds are considered one of the safest investments. This is due to the fact that they are backed by the full faith and credit of the government. Additionally, during a recession, central banks often lower interest rates to stimulate the economy. When interest rates fall, the price of existing bonds rises, which increases the return on bonds. According to the table “Means and Volatilities Conditional on Factor Realizations,” during a recession government bonds have a mean return of 12.3%. This is above large-cap stocks, which yield on average 5.6%, small-cap stocks, at 7.8%, and high-yield bonds, at 7.4%.

Choice A is incorrect. Large-cap stocks, while generally more stable than small-cap stocks, are still subject to the overall economic conditions. During a recession, consumer spending decreases which can lead to lower revenues and profits for these companies, negatively impacting their stock prices.

Choice B is incorrect. High-yield bonds are typically issued by companies with higher credit risk. In a recessionary environment where default risk increases due to deteriorating financial conditions of issuers, these bonds tend to underperform as investors seek safer investment options.

Choice C is incorrect. Small-cap stocks are usually more volatile and risky compared to large-cap stocks. During a recession, these companies may face greater challenges in terms of reduced demand for their products or services and limited access to capital markets which can lead to significant declines in their stock prices.

Things to Remember

• Government bonds are considered one of the safest investments due to being backed by the full faith and credit of the government.
• Central banks often lower interest rates during a recession to stimulate the economy, which can increase the return on bonds as their prices rise.
• Large-cap stocks are subject to overall economic conditions, and during a recession, consumer spending decreases, impacting their stock prices.
• High-yield bonds are typically issued by companies with higher credit risk, making them more vulnerable in a recessionary environment with increased default risk.