How Bonds Affect the Stock Market

Bonds Versus Stocks? Which Is Better for You?

Bonds and Stocks
Which is better? Stock or bonds?. Photo: Spark Studio/Getty Images

The prices of bonds and stocks move in the opposite directions. When stocks go up in value, bonds go down. That's because stocks do well when the economy is booming. Consumers are buying and companies receive higher earnings thanks to higher demand. Investors want to take advantage of higher stock prices, so they sell their bonds and buy stocks.

On the other hand, when the economy slows, consumers buy less, corporate profits fall and stock prices decline.

That's when investors prefer the regular interest payments guaranteed by bonds.

Sometimes, both stocks and bonds can go up in value at the same time. This happens when there is too much money, or liquidity, chasing too few investments. It happens at the top of a market. It could also be the case when some investors are optimistic about the economy's future, and buy stocks. At the same time, others are pessimistic and buy bonds instead.

There are also times when stock and bonds both fall. That's when investors are in a panic and are selling everything. During those times, you might see gold prices go up.

Understanding Bonds and Stocks

Bonds are loans you make to a corporation or government. The interest payments stay the same for the life of the loan. You receive the principal at the end if the company doesn't default. S&P ratings tell you how likely that is to happen.

The bond's value changes over time.

It only matters if you want to sell it on the secondary market. Bond traders compare its return, called the yield, to that of other bonds. Those with low interest rates, or poor S&P ratings, are worth less than higher-yielding bonds.

Stocks are a share of the ownership of a company. Its value depends on corporate earnings.

Corporations release their earnings reports each quarter. The stock's value also changes daily. It depends on traders' estimates of future earnings compared to competing companies.   

Bonds Versus Stocks: Which Is Better for You?

Whether bonds or stocks are a better investment depends on two things. First, what are your personal goals? If you want to avoid losing your principal, enjoy receiving regular payments and aren't concerned about inflation, then bonds are for you. It might be preferable for you if you are retired, or otherwise need to use the investment income.

If you can hold onto your stocks even if the value drops, you don't need income, and want to outpace inflation, then stocks offer more benefits. If you're young and have a well-paying job, then that’s the right target.

Second, how is the economy doing? In other words, in what phase of the business cycle is it? If it's expanding, then stocks provide more benefits. This is because they are gaining value as earnings improve. If it's contracting, then bonds are a better investment. They will protect your investment while providing income. Here's where we are in the current business cycle.

Most financial planners will tell you that being well-diversified is the best investment strategy.

 It means you should have a mix of stocks and bonds in your portfolio at all times. Research has shown that over time, diversification brings the greatest return at the lowest risk.

You can change the mix, or asset allocation, of stocks versus bonds to respond to the business cycle and your financial goals. Overall, having some of each protects you from the unknown.

How the Federal Reserve Uses Bonds to Boost the Stock Market

The Federal Reserve controls iinterest rates through its open market operations. When the Fed wants interest rates to fall, it buys U.S. Treasurys. That's the same as increasing demand for the nation's bonds, which makes their values rise. As with all bonds, when the value rises, interest rates fall.

Lower interest rates put upward pressure on stock prices for two reasons.

First, bond buyers will now get a lower interest rate, and so, a lower return on their purchases. It forces them to consider buying higher-risk stocks to get a better return.

Second, lower interest rates make borrowing less expensive. It can help companies who want to expand. It can assist homebuyers to afford larger houses. It also can help consumers who desire cars, furniture and more education. As a result, low interest rates boost economic growth. It leads to higher corporate earnings and higher stock prices. 

Bonds FAQ