Stock Values and Bond Yields: A Primer

It’s no surprise that stocks have historically performed well in a robust economy. When consumers are spending, companies earn more and stock values tend to increase. Bonds have historically moved in the opposite direction of stocks, often benefiting from slow economic growth and low inflation. Their regular interest payments may be especially attractive to investors when stock prices decline.

A Bond is a Debt

When you purchase a bond, you’re lending money to the bond issuer. In return, the issuer agrees to pay you interest and repay the principal when the bond matures. The issuer can be a corporation; a state, city or federal government; a federal agency; or another entity. Investors buy bonds both for the interest income and to preserve capital.

Bond Price vs. Yield

Bond prices and yields generally move in opposite directions. Rising interest rates mean that new bonds are paying higher yields than older bonds, so when interest rates rise, prices of existing bonds fall. Conversely, when interest rates fall, older bonds are worth more because they’re paying interest at the higher rate. In general, the longer the bond’s term, the greater the probability that its price will be affected by interest-rate fluctuations.

More Risk Equals Higher Yield

Credit quality and default risk play important roles in bond yields. Treasury bonds and other securities backed by the federal government are generally free of default risk.

Corporate bonds present more risk to investors. A company defaults on its bonds when it can’t make principal or interest payments. Bonds with the lowest credit ratings — i.e., junk bonds — have the greatest probability of default and typically offer higher interest rates to compensate investors for the increased risk.

Protect Your Portfolio

When buying bonds, match the bonds’ maturity to your time frame for needing the money. Short-term bonds are appropriate for a two-to-three-year period, while intermediate bonds can be a good investment for cash you’ll need in five to ten years.

As you near retirement, you may want to consider reducing some of your equity risk in anticipation of market volatility. Revisit your asset allocation with your financial professional to see whether changes are warranted.