The Relationship Between Stocks and Bonds: Price and Returns
Stocks and bonds are two common investment options to build wealth for your future. It’s important to know the difference – and how their dynamics can dramatically affect prices.
What Is the Difference Between Stocks and Bonds?
Stocks are shares of a company giving the investor partial ownership, while bonds are loans provided by the investor to an entity that agrees to pay it back with interest for a determined time period.
Stocks are a riskier investment than bonds because their value is dependent on the success of a particular company. That success is impacted by a number of factors which can make stock value change often and quickly. In addition to this, stocks are riskier than bonds because equity holders are second in line after bondholders if the company was not to succeed or not able to pay obligations.
When an investor buys a bond, it acts as a loan towards an entity. The entity agrees to pay it back with interest. Because of this, bonds can be considered a low-risk investment with a steady source of return (even if it’s nominal).
How Interest Rates and Inflation Affect Bond Returns
Bonds returns are known as a “yield” and they’re dependent on the current rate of inflation, the financial health of the issuer (quality), and the duration of the bond.
The interest rates depend on the current rate of inflation (which is the increase in cost of goods and services). When inflation is high, interest rates typically rise.
A stock’s return, however, is based on its current market price. If you bought stock for $40 and the market price increases by $5, then you’ve made a return of $5 on your initial investment.
Stocks and Bonds Pricing Relationship
When it comes to prices, stocks and bonds typically have an inverse relationship. Falling stock prices are a signal of falling confidence in the economy. When investors pull money out of stocks, they seek less risky investments like bonds.
When a great deal of money leaves stocks and is put into bonds, it often pushes bond prices higher and yields down due to increased demand. This is especially true for already-existing bonds with higher yields (returns) as opposed to newly-issued bonds that normally offer lower yields.
Do Rising Stock Prices Hurt Bond Prices?
Not really. Although falling stock prices can cause investors to flee to the safety of bonds, rising stock prices don't necessarily make bonds unattractive. Instead, bond prices are impacted by perceived inflationary pressures in the economy. If it looks like inflation is increasing, bond prices will fall and yields will rise.
Why Do Bond Prices Go Down When Interest Rates Go Up?
When interest rates rise, bond prices fall and vice versa. The price of the bond adjusts to stay competitive within the market.
Let’s look at two examples of what rising inflation and interest rates look like:
1. A Moderate Rise in Inflation and Interest Rates
Let’s say that inflation and interest rates rise to 4%. The result would be higher stock prices. Despite this, more people would be investing in stocks rather than purchasing bonds. That's because a moderate rise in inflation and interest rates implies that the economy is getting stronger – and stocks do well when the economy is strengthening. Bonds, on the other hand, are purchased more often when the economy is declining.
However, it is important to note that bonds will decrease as well as interest rates rise. In general, for every 1% increase in interest rates a bond’s price will decrease to the extent of the duration in years. For example if a bond’s duration is 4 years, a 1% increase in interest rates will result in a 4% decline in that bond’s price.
2. A Significant Rise in Inflation and Interest Rates
Let’s look at a significant rise in inflation and interest rates. If inflation and interest rates rise to the 6% to 8% range, the economy would start to face a powerful headwind due to corporate profits being eaten up by higher inflation. Companies would become hard-pressed to generate inflation-adjusted profit growth in such an environment (they’re bad for stock prices) and many investors would increasingly move away from stocks to bonds. The Federal Reserve would then start to hike interest rates until they are high enough to stop the rise of inflation.
Scenario 2 isn’t actually hypothetical: In the 1970s, inflation soared toward the double-digit mark with government bonds handily yielding 10%. When that happened, few wanted to own seemingly precarious stocks when there were bonds with far juicier yields. The massive bear market in the 1970s’ stock market was directly tied to these impressive bond yields. In this case, falling bond prices (as yields rise) and falling stock prices were "highly correlated."
With current inflation at multi-decade lows, few people are thinking about this topic at the moment. But if interest rates start to rise in upcoming quarters, this is an incredibly important relationship to understand.
Stocks vs Bonds: What Should You Choose to Invest In?
For example, if you’re in your 20’s – and have decades until retirement – you should have a riskier, more aggressive investment portfolio that is heavy in stocks. If you are in your 60’s and nearing retirement, select a portfolio that is heavier in bonds and low-risk asset classes. The key to investing in stocks and bonds is an appropriate balance of each based on your risk tolerance.
Further Reading on Goals and Risk Tolerance
If you want to read more about stocks and bonds check out the articles below: