What’s the relationship between stocks and bonds?

Stocks vs bonds: the need to knows

Stocks and bonds compete for a finite quantity of investor funds. Bonds are typically seen as a safer investment, while stocks usually offer greater opportunity for profit. This creates an environment where investors will often favour one over the other in order to rebalance their portfolio, particularly in times of positive or negative economic growth.

Let’s look at the differences between stocks and bonds and why investors may choose one over the other.

1. Stocks: what to know and when might you invest?

Stocks are units of ownership in companies and can entitle shareholders to receive benefits such as dividends and voting rights in company decisions.

Investing in shares can be risky, as their value is affected by a number of factors – like the state of the economy, interest rates, market sentiment and the company’s earnings reports.

The upside of investing in stocks over bonds is that the potential for profits can be greater. When companies perform well and economic outlook is positive, investors buy up shares in the hopes of making a decent profit. The more buy-up there is, the better the company performs, which could drive up the stock price.

2. Bonds: what to know and when might you invest?

Bonds are debt-based investments issued by governments and companies when they need to raise additional capital. In return for loaning money, investors receive regular interest repayments (called coupons) and get their initial capital back at a specified time in the future (called the maturity date).

Bonds are considered to be safer investments than stocks, particularly those issued by governments that have little or no history of defaulting on bond repayments, like the UK.

However, corporate and government bonds do carry risk and there have been instances where companies and governments have not repaid their loans to investors. For example, in 2020, Ecuador and Lebanon defaulted on government bonds, and healthcare consulting company Quorum Health Corporation defaulted on $14.3 billion worth of bonds.

Because bonds are often safer investments, their return is usually much lower than that of stocks. However, in times of economic trouble and stock market crashes, investors often ditch stocks in favour of bonds not only because of the lower risk involved, but because economic contractions lead to reduced consumer spending, resulting in lower corporate profits and, therefore, lower share prices.

How do bond yields affect share prices?

To understand how bond yields affect share prices, we need to understand the inverse relationship between bond prices and bond yields. That is, when bond values head in one direction, that bond’s yield heads in the other.

Let’s say you buy a bond worth £1000. The fixed coupon rate is £20 annually. This means the yield is 2%, calculated as follows:

(£20 ÷ £1000) x 100 = 2%

Now, let’s see what happens if the bond price in the example rises to £1500. Because this is a fixed-interest investment, the coupon stays the same at £20 annually, which causes the yield to drop to 1.33%. Here’s how that works:

(£20 ÷ £1500) x 100 = 1.33%

The same is true the other way round. If the bond’s value decreases, the yield will increase. Using the same example, let’s now imagine the bond price decreased to £750. The yield would increase to 2.66%, as follows:

(£20 ÷ £750) x 100 = 2.66%

Lower bond yields can lead to higher share prices

Because every investor wants to maximise their potential profit, many will dump low-yielding bonds in favour of stocks with potentially higher returns. The more investors buy stocks, the higher share prices could rise.

What role does inflation play in the bond and stock markets?

Inflation must be carefully balanced in order for bonds and stocks to perform well. If inflation is too high, it erodes purchasing power. If it’s too low, there’s a risk of falling behind foreign rivals.

The effects of inflation on the stock market are complex and there isn’t a catch-all rule to be applied to all shares. However, we can say to a certain degree the probability of how inflation rates might affect a company’s share price.

Typically, growth stocks, those aimed at growing over the longer term with less value in the current, benefit from lower inflation levels because their value is determined on what their future earnings are going to be. When inflation rises, interest rates rise with it, which erodes the value of future company earnings.

On the other hand, value stocks, which are priced lower than their intrinsic value, tend to fair better during high-inflation periods. This is because their larger current cash flows are more valuable than those of growth stock’s distant potential returns. Investors need to see higher returns when inflation rises to make ‘real’ returns, so they tend to stick to stocks that can withstand increased inflation in the present.

For fixed-return bonds, inflation will always have a negative impact, because if the rate of return on the bond is lower than that of inflation, real returns are negative. However, inflation-linked bonds aren’t negatively affected by rising inflation, as they’re linked to price indexes. So, investments in inflation-linked bonds won’t be impacted by rising or falling inflation rates.

What role do interest rates play in the bond and stock markets?

When interest rates rise, consumers and businesses pay more to borrow money, which has a knock-on effect. For consumers, there’s less cash to spend on goods and services. For investors, there are less funds available to buy stocks. And for businesses, there’s less money for expansion, all leading to lower company earnings and share values.

Conversely, when interest rates fall, it creates a catalyst for growth, as consumers and businesses spend more money. Greater consumer spending and more business funding lead to higher current and future demand for companies’ share prices.

The inverse relationship between bonds and interest rates means that rising interest rates negatively affects the value of bonds. This is because newer bonds issued at the higher rate automatically devalue existing bonds at the lower rate.

Stocks and bonds: what to look out for

If you’re interested in investing in stocks and bonds, examining US markets is a good place to start for a number of reasons:

• US Treasury bond yields can have an impact on the global bond market, because the US is seen as a safe haven and tends to represent global market sentiment
• The US Federal Reserve (Fed) has a profound effect on bond and stock values. When it wants to lower interest rates, the Fed buys Treasury bonds, increasing their value
• The S&P 500 tracks the stock performance of the top 500 largest companies listed in the US, giving a good indication of the direction an entire market is headed

How to invest or trade in stocks and bonds

1. Do your research; our free app IG Academy is a great tool
2. Open an account to get started or practise on a demo
3. Place your trade

You can trade in stocks and bond ETFs directly via our share trading platform.

You can also trade shares, government bonds and interest rates with CFDs. However, remember these are complex and leveraged derivative products, so your potential for profit and loss is magnified. This is because you trade on margin, which allows you to open a position with a fraction of the total value of the trade.

Stocks, bonds and their prices summed up

• Lower bond yields could lead to higher share prices and higher bond yields could lead to lower share prices
• Rising inflation and interest rates can erode stock and bond values