Stocks and bonds are common options to build wealth for your future, but do bonds go up when stocks go down (and vice-versa)? Discover how the dynamics of these two investment options can dramatically affect your portfolio.
The Difference Between Stocks and Bonds
Stocks are shares of a company that give investors partial ownership. 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 that can make stock values change often and quickly. Additionally, if the company is unsuccessful or unable to pay obligations, equity holders are second in line (after bondholders).
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 are considered a low-risk investment with a steady source of return (even if it’s nominal).
How Interest & Inflation Rates Affect Bond Yields
Bonds returns (also known as “yields”) and they’re dependent on the current rate of inflation, the financial health of the issuer, and the duration of the bond.
Interest rates depend on the current rate of inflation (which is the increase in the cost of goods and services). That’s why, 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, you’ll have made a return of $5 on your initial investment.
The Relationship Between Bond Yields and Stock Prices
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.
So why do bonds go up when stocks go down? 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 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 & Interest Rates
Let’s say that inflation and interest rates rise to 4%, resulting in 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.
It’s important to note that bonds will also decrease 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
If inflation and interest rates rise to the 6% to 8% range:
- The economy will start to face a powerful headwind due to corporate profits being eaten up by higher inflation.
- Companies will become hard-pressed to generate inflation-adjusted profit growth in such an environment (they’re bad for stock prices).
- The Federal Reserve will start to hike interest rates until they are high enough to stop the rise of inflation.
- Many investors will increasingly move away from stocks to bonds.
This scenario isn’t hypothetical: In the 1970s, inflation soared toward the double-digit mark with government bonds handily yielding 10%. When this happened, few wanted to own seemingly precarious stocks when there were bonds with far juicier yields. The massive bear market of the 1970s was directly tied to these impressive bond yields, and falling stock prices and bond prices (as yields rose) were 'highly correlated.'
Stocks vs Bonds: What Should You Choose to Invest In?
For most investors, it’s important to create a balanced portfolio that includes both stocks and bonds. This portfolio should have various levels of risk, depending on how close you are to retirement.
For example, if you’re in your 20s – and have decades until retirement – you should have a riskier, more aggressive investment portfolio that’s heavier in stocks. If you’re in your 60s and are nearing retirement, select a portfolio that’s 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:
