The bond market is sometimes referred to as “smart money.” It gets this name because bond traders are usually the first to recognize certain elements of monetary or fiscal policy which may cause them to sell or buy bonds. Traditionally purchased or sold bonds are sovereign bonds issued by a country or region.
The bond market is driven mainly by future inflation expectations and economic growth. Its impact on the interest rate outlook is direct as bond prices tend to move in the opposite direction of the yield they pay. Bond investors are not always right, but they are often seen as less likely to speculate compared to stock or commodity investors.
There are many parts of the bond market. Each portion of sovereign bond market is part of the yield curve. Traders will refer to the short end, the belly, and the long end of the yield curve when referring to bonds.
Bond investors have a fairly strong track record of being able to predict the future of the economy. Several tools can be used to view how bond investors see how stocks may perform in the future.
How Do Bonds Work?
Bonds are obligations governments and corporations issue when they want to raise capital. When you purchase a bond, you essentially lend money to the issuer, who agrees to pay the loan back at specific intervals. You will receive the face value of the loan and an interest payment along the way. Some bonds provide interest semi-annually, but others pay once a year or even quarterly.
Bonds, as opposed to stocks, do not provide you with ownership equity. Rather, bonds provide you with a stream of income. Bond prices move in the opposite direction of the yield they produce. If the yield moves from 3% to 4%, the cost of that bond will likely move lower.
While the bond price will gyrate with market sentiment, if you purchase a bond and hold onto it until maturity, you will receive the entire face value plus interest in return. If you decide to sell the bond before maturity, you will receive the market rate, which might be more or less than the original face value you paid, plus any interest you received while owning the bond.
The coupon of a bond is the interest payment that you receive. The yield is the interest rate usually quoted on an annual basis. The face value of a bond is the amount of money you initially used to purchase the bond. The price of the bond is the cost of the bond.
Why Do Stock Investors Care About the Yield Curve?
Some people look at the bond market as smart money and evaluate the likely interest rates that will be in place, which could impact the value of stocks. In theory, stock values are based on discounted cash flows of the earnings produced by a company in the future.
The stock market is a forward-looking instrument where investors evaluate what could happen in the future and how that will impact the earnings of the companies they decide to buy and sell. If the future payments of a company change, the value of the company will also change. The concept is called the discounted net present value of a cash flow.
For example, if you believe that the company whose shares you are purchasing will make $100,000 in one year at the current interest rate of 3%, the present value of that $100,000 is $97,000, which discounts the value of the $100,000 by 3%. If the one-year interest rate increases to 4% from 3%, the discounted cash flows’ net present value will decline from $97,000 to $96,000.
If the discounted cash flows drop, the company’s net present value should also be lower. The upshot is that if interest rates increase and the cash flows that a company is likely to make in the future remain the same, the value of a company declines with rising interest rates. You should also know that yields form a significant part of forex trading, as they can impact currency valuations.
What is forex trading? Essentially forex trading is the buying of one currency using another, with a focus on using the price fluctuations between the two to make a potential profit. When it comes to bonds, sovereign yields are the spreads that can be the leading indicator for forex.
Another reason a stock price might decline if interest rates rise is that bonds are an alternative investment to dividend-paying stocks. A dividend is a portion of the profits that the company returns to its investors. Many companies pay dividends which are added to the returns you receive from owning the stock.
Stock investors looking for income-producing equities that could return dividends will compare the dividend they receive to the interest rate they might attain if they own a bond instead of a stock. If the interest rate on a bond rises relative to the dividend yield on a stock, an investor might consider purchasing a bond instead of a stock.
What is Dividend Yield?
When you purchase a stock and want to attain yield from dividends, you can determine the yield you will receive by calculating the dividend yield. To calculate the dividend yield, you want to add the dividends you would likely receive during a year.
You can do this by looking at past dividends to generate a figure. You can also estimate the dividends by multiplying the latest dividend by four, assuming that the company pays quarterly dividends.
To calculate the dividend yield, you would divide the price of the stock you are about to purchase by the total dividend you are likely to receive. For example, say company XYZ pays $1 per quarter, and the stock price is $100. The dividend yield you could receive is 4% ($4 / $100).
If you compare that 4% to a sovereign rate, like the one-year treasury rate, you can then determine if it’s worth risking capital to make 4%, compared to a risk-free rate of return from a one-year treasury rate.
For example, If the risk-free rate of holding a treasury is more than the dividend yield of a stock you are planning to purchase for dividend income, then you might decide that you could be better off purchasing the bond than the stock. Alternatively, your decision might be different if you also believe that the stock can appreciate over time.
What Does the Shape of the Yield Curve Say?
Another way the bond market impacts stock prices is through the shape of the yield curve. When investors talk about the shape of the yield curve, they refer to the interest rate paid for each maturity. You are comparing the yields for less than 1 year, 2 year, 5 year, 10 year, and 30 year yields. A normal yield curve has a shape where longer maturity yields are higher than short maturity yields.
The longer you lend your money to a government or corporation, the higher the yield you might want to receive. When a yield curve is inverted, short-term maturities have a higher yield than long-term maturities. Traders often look at the yield curve on a graph to evaluate the shape.
The shape of the curve can flatten where short-term yields and long-term yields converge. The shape of the yield curve can also steepen where short-term yields and long-term yields diverge. Several changes to a yield curve might give you a clue about what could occur with stocks.
Generally, when the yield curve is flattening, a central bank increases rates, and short-term rates rise faster than long-term rates. Usually, this occurs when inflation is growing, and the central bank wants to reduce growth. When short-term rates decline faster than long-term rates, a central bank usually reduces interest rates in an attempt to induce growth.
Yield curves are usually used as a bellwether for the future direction of growth and inflation. When a yield curve is steepening, rates usually fall, and this period is usually beneficial for stock prices as the discounted cash flows are rising. When a yield curve is flattening, rates are generally rising and could potentially push an economy into recession, reducing the cash flows of stocks.
The Bottom Line
The upshot is that the bond market is a gauge used to determine the value of stocks. Bonds are similar to loans in that you are lending your money to an issuer in return for an interest payment over time. When interest rates rise, the discounted cash flows of stocks decline.
When interest rates fall, discounted cash flows rise. Bonds are also seen as an alternative to stocks. Some investors will compare the dividend yield received from a stock to the risk-free rate received from a bond yield.
The bond market also has a yield curve. The shape of the yield curve and how it changes may tell you what type of environment the market is experiencing. If a curve is flattening, central banks usually raise rates, which is less beneficial for stocks. When a yield curve is steepening, a central bank generally reduces rates, which is better for stock prices.