In this treacherous trading environment, prudent investors must analyze all aspects of the financial market, even if they mainly invest in equities. Bonds and the central bank of the United States of America, the Federal Reserve, play an integral role in shaping the direction of stock prices to the dismay of investors.
Bonds are fixed-income instruments designed for capital preservation, not capital appreciation. Bonds allow investors to receive a regular interest stream of cash flow until maturity. At maturity, the bondholder receives principal amount back. There are varying degrees of bonds ranging from treasury bonds to corporate bonds to mortgage bonds to convertible bonds. In between these classes of bonds are other fancy bond like instruments investors can choose from. Due to the popularity of a fixed income stream of payments and return of principal at settlement, bonds are a popular choice for investors who are risk averse and fear losing lots of capital in equities.
Bonds are backed up the issuer’s credit, which then helps determine the coupon rate for the bond of the issuing agency. For instance, the U.S. Federal Government offers Treasury bonds with the full faith of repayment at maturity. No other entity in the world can offer this guarantee of return. Bonds issued by the federal government have the lowest yields because of this certainty. For all other bonds issued outside the realms of the U.S. Federal Government, bondholders have the right to seize assets if a company declares bankruptcy.
The Federal Reserve greatly affects the direction of the bond market. Over the last decade, interest rates have been at historical lows because of the Great Recession and the Federal Reserve’s attempt to rejuvenate a weak economy caused by a severe credit crisis. During this period, investors moved away from the bond pits to the stock market in order to earn higher returns compared to what bonds were offering during this period. Companies that are bond equivalent in the stock market, utilities for instance, soar higher during low interest rates periods because of the attractive yield their dividend provides.
The immense size of the bond market and the role of the Federal Reserve in handling the economy definitely impacts the direction of stocks. The Federal Reserve is designed to regenerate weak economies and promote job creation and secondly fight off inflation when the economy is roaring too fast. One of the tools described above utilized by the Federal Reserve is their ability to raise and lower interest rates. When the economy is sluggish, the Federal Reserve lowers interest rates in an effort to encourage companies to finance investments more cheaply, which in turn churns the economy and promote job creation. However, when the economy is roaring and inflation is raging, the Federal Reserve will raise interest rates in an effort to control rising prices.
So how do bonds and the Federal Reserve actions sway stock prices? Let’s start with the Federal Reserve first. The Federal Reserve actions and even their words alone move stock prices for better or worse. If there is any mention of potentially raising interest rates at the next Fed meeting, stock prices tend to tumble. Rising interest rates cause stock prices to fall because bonds are now more attractive to investors searching for higher yields. When the Fed announces they are lowering interest rates to help promote economic growth or stability, stocks rally because bonds are no longer as attractive since their yields will fall.
Stock yields fall when stocks rally. When a stock price rises, an original yield of 5% might actually be 2.5% in the future. Investors need to recognize this impact on stocks they own that offer bountiful dividends and high yields. For investors only interested in capital preservation and searching for the best yield available, whether stocks or bonds, they are more likely to leave stocks when yields begin to decline despite strong fundamentals of a company or future prospects. Investors who use equities for capital appreciation understand yield and dividend is a nice benefit to owning a stock, but it is not the end all be all.
For investors who own a stock for the long-run, spotting investors only interested in taking yields is critical to understand a stock’s performance. Understanding this basic notion will help you as an investor better determine why a higher-yielding stock is selling off for absolutely no basis and help you determine an exit point for taking profits. In addition, rising interest rates shouldn’t mean all stocks should fall in tandem. Rising interest rates does mean it will be more difficult for firms to finance operations. However, it is important to remember interest rates traditionally rise during economic booms and some industries thrive during booms. For example, rising interest rates shouldn’t necessarily impact housing sales because if the economy is roaring then consumers are more likely to purchase homes. Understanding how different industries react to the Fed’s actions and the bond pits will help you as an investor spot terrific buying opportunities.
