Bonds compete with stocks for investors’ dollars because bonds are often considered safer than stocks. However, bonds usually offer lower returns. Stocks tend to do well when the economy is booming. When consumers are making more purchases, companies receive higher earnings thanks to higher demand, and investors feel confident. One of the best ways to beat inflation is to sell bonds and buy stocks when the economy is doing well. When the economy slows, consumers buy less, corporate profits fall, and stock prices decline. That’s when investors prefer the regular interest payments guaranteed by bonds.
The Relationship Between Stocks and Bonds
Sometimes, both stocks and bonds can go up in value at the same time. This happens when there is too much money, or liquidity, chasing too few investments. It happens at the top of the market. It could occur when some investors are optimistic and others are pessimistic. There also are times when stocks and bonds both fall. That tends to be when investors are in a panic and sell their investments.
Understanding Bonds and Stocks
Bonds are loans you make to a corporation or government. The interest payments stay the same for the life of the loan. You receive the principal at the end if the corporation or government doesn’t default. S&P ratings can tell you the likelihood of that happening before you invest in bonds. A bond’s value changes over time, which matters only if you want to sell it on the secondary market. Bond traders compare their returns, called the “yield,” to that of other bonds. Those with low interest rates or poor S&P ratings are worth less than higher-yielding bonds. Stocks are shares of ownership in a company. Their values depend largely on corporate earnings, which corporations report each quarter. Stock values change daily, depending on traders’ estimates of future earnings, compared to those of competing companies.
Are Bonds a Better Investment Than Stocks?
Whether bonds or stocks are a better investment for you depends on two things. First, what are your personal goals? If you want to avoid losing your principal, enjoy receiving regular payments, and aren’t concerned about inflation, then bonds are for you. They might be preferable for you if you are retired or otherwise in need of using the investment income. If you can hold on to your stocks even if the value drops, you don’t need income, and you want to outpace inflation, then stocks offer more benefits. If you’re young and have a well-paying job, then that’s the right target. Second, how is the economy doing? In other words, what phase of the business cycle is it? If it’s expanding, then stocks provide more benefits. This is because they are gaining value as earnings improve. If it’s contracting, then bonds are a better investment. They will protect your investment while providing income.
The Federal Reserve, Bonds, and the Stock Market
The Federal Reserve controls interest rates through its open market operations. When the Fed wants interest rates to fall, it buys U.S. Treasury notes. That’s the same as increasing demand for the nation’s bonds, which makes their values rise. As with all bonds, when bond values rise, interest rates and stock prices tend to go down. On the flip side, lower interest rates and lower bond values put upward pressure on stock prices for two reasons. First, bond buyers receive a lower interest rate and less return on their investments, which forces them to consider buying higher-risk stocks to get a better return. Second, lower interest rates make borrowing less expensive. They help companies that want to expand. They help homebuyers afford larger houses. They also help consumers who desire cars, furniture, and more education. As a result, low interest rates boost economic growth. They lead to higher corporate earnings and higher stock prices.
