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Bond Yields and Their Relation to Stock Markets

STHQ does not trade bonds but we feel that you should know how the bond markets work as they do relate to the stock market much like the price of oil effects the stock market.  Bond prices change on a daily basis just like publiclytraded securities.  In the bond world they talk about bonds as if everybody held them to maturity. The reality is that very few people ever hold them that long.  They recently brought back the 30 year bond; imagine holding a bond for 30 years Talk about a turtle of an investment. 

The conventional wisdom is that stocks are for younger people with risk tolerance because they have many years ahead of them.  Bonds are normally for older people who are entering retirement and want less risk. If this is the case who would buy the bonds When I am 62 I cannot see myself buying a 30 year bond and cashing it at age 92. 

The fact is bonds are used as a trading vehicle by the majority of bond market participants and are rarely held to maturity.  In this way bonds are much like stocks futures commodities and the foreign exchange. A bond does not have to be held to maturity. At any time a bond can be sold in the open market where the price can fluctuate sometimes dramatically.  The yield in the ten year bond is moving higher as mentioned in the commentary last night.  This will affect the stock market negatively if it continues. 

The Yield
The yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated by the following formula: yield coupon amount/price. When you buy a bond at par yield is equal to the interest rate. When the price changes so does the yield. 

Example:
If you buy a bond at its $1000 par value with a 10% coupon the yield is 10%. But if the price goes down to $800 then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is now worth $800. Conversely if the bond goes up in price to $1200 the yield shrinks to 8.33% ($100/$1200). 

Price and Yield Link
The yield's relationship with price can be summarized as follows: when price goes up yield goes down and vice versa.  In other words bond prices and their yields are inversely related. 

Here is the main point of confusion. How can high yields and high prices both be good when they cannot happen at the same time The answer depends on your point of view. If you are a bond buyer you want high yields. A buyer wants to pay $800 for the $1000 bond which gives the bond a high yield of 12.5%. On the other hand if you already own a bond you have locked in your interest rate so you hope the price of the bond goes up and profit even more when you sell the bond. 

Relationship with Stocks
The single most important factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise the prices of bonds in the market fall thereby raising the yield of the older bonds and bringing them into line with the newer bonds being issued with a higher coupon.  This should result in a stock sell off because bonds are safer. If they are getting cheaper and yielding more the flight to safety is the common sense investment. 

Conversely when interest rates fall the prices of bonds rise thereby lowering the yield of the older bonds and bringing them into line with the newer bonds being issued with a lower coupon.  Investors then seek a better return elsewhere flocking to stocks and forcing stock prices higher. 

There is a relationship between the stock market and the bond market and knowing what is going on in the bond market could help you with your stock trading.





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