How Bonds Affect the Stock Market

Which Investment Is Better for You?

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Bonds affect the stock market by competing with stocks for investors' dollars. Bonds are safer than stocks, but they offer lower returns. As a result, when stocks go up in value, bonds go down.

Stocks do well when the economy is booming. When consumers are making more purchases, companies receive higher earnings, thanks to higher demand, and investors feel confident. One of the best ways to beat inflation is to sell bonds and buy stocks when the economy is doing well. 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.

Key Takeaways

  • Bonds are safer than stocks, but they offer lower returns. When stocks go up in value, bonds go down.
  • Bonds are loans you make to a corporation or government; stocks are shares of ownership in a company.
  • Whether bonds or stocks are better for you depends on your investment goals, but it's smart to have a diversified portfolio with a mix of both.

The Relationship Between Stocks and 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 the market. It could occur when some investors are optimistic and others are pessimistic.

There also are times when stocks and bonds both fall. That's when investors are in a panic and selling everything. During those times, gold prices often rise.

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 borrower doesn't default. S&P ratings can tell you how likely that is to happen.

A bond's value changes over time, which matters only if you want to sell it on the secondary market. Bond traders compare their 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 shares of ownership in a company. Their value depends largely on corporate earnings, which corporations report each quarter. Stock values change daily, depending on traders' estimates of future earnings, compared to those of competing companies.

Bonds vs. Stocks: Which Are Better for You?

Whether bonds or stocks are a better investment for you 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. They might be preferable for you if you are retired or otherwise in need of using the investment income.

Most financial planners will tell you that being well-diversified is the best investment strategy. That 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 vs. bonds to respond to the business cycle and your financial goals.

If you can hold on to your stocks even if the value drops, you don't need income, and you 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, 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.

The Federal Reserve's Role

The Federal Reserve controls interest 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 receive a lower interest rate and less return on their investments, which forces them to consider buying higher-risk stocks to get a better return.

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

Frequently Asked Questions (FAQs)

What percentage of my investments should go toward stocks vs. bonds?

The ideal ratio of stocks and bonds will vary based on your investing goals and age. An extremely aggressive portfolio would have 90% or more invested in stocks. The higher the percentage of bonds that you add in, the less aggressive it becomes. Many financial planners recommend starting with mostly stocks when you're young and gradually shifting toward a more balanced portfolio as you get closer to retirement.

Which is paid first, stocks or bonds?

If a company goes bankrupt, lenders are the first to receive their money. Shareholders receive money last, if at all. Since bonds are a type of loan, you're more likely to be paid back if a company goes under.

Why do corporations issue bonds and stock?

Bonds and stocks are both ways for corporations to raise capital. Bonds allow a company to raise money without diluting ownership shares but they require fixed repayment. Stocks can be a way to raise more money but they reduce the shares (and returns) of existing owners.