How Bonds Affect the Stock Market

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.

Conversely, when the economy slows, consumers buy less, corporate profits fall, and stock prices will dip.

That's when investors want the steady interest payments guaranteed by bonds.

However, sometimes both stocks and bonds go up in value at the same time. That's usually because there is too much money, or liquidity, chasing too few investments, as is the case at the top of a market. It could also be the case when some investors are optimistic about the economy's future, and buying stocks, while others are pessimistic and buying bonds.

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.

The bond's value changes over time. That only matters if you want to sell it in the secondary market.

Bond traders compare its return, called its 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 the company. Their value depends on corporate earnings. These are released each quarter. The stock's value changes daily depending on traders' estimates of those projected future earnings compared to the competition.

 

Bonds vs. 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. That might be the case if you are retired, or otherwise need to use the investment income.

If, on the other hand, 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 would describe your situation.

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 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 the best investment strategy is to be well-diversified.

That means you should have some stocks and some 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 vs. bonds to respond to the business cycle and your financial goals. However, having some of each protects you from the unknown.

How the Federal Reserve Uses Bonds to Boost the Stock Market

The Federal Reserve controls interest rates through its open market operations. When the Fed wants interest rates to fall, it buys U.S. Treasuries. 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 therefore return, on their purchases. That forces them to consider buying higher-risk stocks to get a better return.

Second, lower interest rates make borrowing less expensive. That helps companies who want to expand, homeowners who wish to buy new houses, and consumers who desire cars, furniture and more education. As a result, low-interest rates boost economic growth. That leads to higher corporate earnings and higher stock prices. 

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