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Bond movements and stock prices

Lesson in Course: Bonds (advanced, 9min)

Most investors own both stocks and bonds. What do we need to know about the relationship between them?

Eureka!

What it's about: The U.S. 10-year Treasury is considered one of the safest investments and its yield impacts many other investments.

Why it's important: Investors will move their money from stocks to bonds when the stock markets aren't doing well or they are concerned about the future.

Key takeaway: In general, bond prices and stock prices move in opposite directions.

Investors often look at the U.S. Treasury yield as an indication of future economic health. To review quickly, the U.S. Treasury borrows money for the Federal Government to spend by issuing out debt. What we call the Treasury's debt depends on its maturity:

  • Treasury bills = maturity of less than 1 year
  • Treasury notes = maturity of 2 to 10 years
  • Treasury bonds = maturity of 10 to 30 years

Investors worldwide buy U.S. Treasury debt as a safe place to park their cash because it's very unlikely the U.S. government will default.

Ten-year Treasury Bond

Out of the government's different debt maturities, the 10-year Treasury gets a lot of attention because it plays a big role in the economy and our lives. 

10-year Treasury bonds serve as warnings for the economy

In fact, most interest rates we come across, like credit cards, auto loans, and mortgage rates are determined based on the 10-year yield

 

Relationship with stocks

Bond price vs. stock price

Historically, bonds and stock prices have an inverse relationship

Inverse relationships work like seesaws

When bond prices are going up, stocks are going down, and vice versa. When investors are afraid or pessimistic about the future, they sell stocks and look to put their money in safer investments like bonds. The increased stock selling causes stock prices to drop, and the increased bond buying forces bond prices to go up.

Bond yield vs. bond price

The bond yield also has an inverse relationship with bond price. 

Bond yield and stock price travel the same direction

A bond’s yield is determined by dividing the coupon payment by the bond’s current price. Since the bond’s coupon payments are fixed, the bond’s yield will be higher when the price of the bond goes down and the yield will fall when the price rises.

Example of yield vs price

We buy a $100 bond that has a 5% coupon rate, promising to pay $5 every year. When the bond is issued, it has a 5% yield ($5/$100). If the price of our bond rises to $105, the yield is 4.7% ($5/$105).

 

Bond yields and stock prices typically move in the same direction since they both move in the opposite direction of the bond prices.

Check out this short video for an overview of bond prices and yields
https://www.youtube.com/watch?v=mS7t91U9Qqg
 

The exception

Sometimes bond yields spike quickly which destabilizes the stock market. In many cases, a rapidly rising 10-year Treasury yield (blue) causes stocks to drop (red). 

Some reasons folks use to justify the drop in stock prices include:

  1. Sector rotation
  2. Inflation concerns
  3. The increased cost to borrow for companies

Historically, stock prices recover when the spike in yields settles. Our Central Bank, The Federal Reserve, is in charge of preventing yields from spiking.

Actionable ideas

While it’s important to keep track of what’s happening in the bond markets, it’s difficult to take advantage of rapid changes. Proper diversification will help soften any blow to your portfolio. However, in almost all cases stocks usually rebound shortly after, so the best action could be to do nothing or buy the dip (buy when the price drops).

 

Glossary

What is Bond yield ?

A bond’s yield is determined by dividing the coupon payment by the bond’s current price. Since the bond’s coupon payments are fixed, the bond’s yield will be higher when the price of the bond goes down and the yield will fall when the price rises.