If you have ever wondered about the definitions of bonds and stocks, and the interplay between the two investment vehicles, this blog is for you.

Let's first answer the basics:

What is a bond?

A bond is essentially a loan. When the government or a corporation needs to raise money, they sell bonds. In return for the loan from the bondholder, the government or corporation agrees to pay the lender back the face value of the bond on a specific date, i.e., when the bond "matures," and to pay periodic interest payments, usually twice a year, until the loan is repaid.  As with any loan, interest rates impact the value and yield of bonds. Bonds with longer maturities have a greater level of risk due to changes in interest rates over time, so they generally offer higher yields to be more attractive to potential buyers. Conversely, bonds with shorter maturities have less perceived risk and therefore offer lower yields. The relationship between maturity and yields is called the yield curve.

Bonds are typically set at $1,000 face value, or par. The actual market price of a bond depends on various factors, including the credit quality of the issuer, the length of time until expiration, and the rate the bond issuer will pay on the face value of the bond (known as the coupon rate) as compared to the general interest rate environment.

If a bondholder holds their bonds until maturity, they will get their principal (face value) back plus interest. However, if a bondholder decides to sell their bonds on the open market, the bond's price will vary inversely with interest rates. When interest rates go up, bond prices fall, which equalizes the interest rate on the bond with prevailing rates, and vice versa.

Types of bonds

• Corporate bonds are offered by private and public corporations and include investment-grade bonds, which have a higher credit rating and are less of a credit risk than high-yield corporate bonds, which offer higher interest rates in return for their increased risk. 

• Municipal bonds are issued by states, cities, counties, and other government entities, and can be: (i) backed by an issue's general fund or specific taxes (general obligation bonds); (ii) backed by revenues from a specific project or source, such as highway tolls or fees (revenue bonds); or (iii) on behalf of private entities such as non-profit colleges or hospitals (conduit bonds). 

• U.S. Treasury bonds are offered by the U.S. Department of the Treasury on behalf of the U.S. government, and include Treasury Bills (short term securities that mature within a year), Notes (securities that mature with 10 years), Bonds (securities that typically mature in 30 years and pay interest every six months), and Tips (notes and bonds whose principal is adjusted based on changes in the Consumer Price Index).  

What is a stock?

A stock represents partial ownership, or equity, in a company. You purchase equity in the company through shares that are valued at a specific price. Your ownership value in the company increases and decreases with the value of the stock.

Shareholders have certain rights – the right to vote on certain business decisions, the right to view certain financial documents and corporate records, the right to receive dividends, the right to transfer ownership of stock, and the right to sue for acts of wrongdoing.

Types of stocks

• Owners of common stock are entitled to vote and receive dividends.
• Owners of preferred stock do not usually have voting rights but receive dividend payments before common stockholders and have priority over common stockholders if the company goes bankrupt and liquidates its assets. (It should be noted, however, that bondholders will be paid before holders of preferred stock.

Stock Categories

• Growth stocks have earnings growing at a faster rate than the market average. They rarely pay dividends.
• Income stocks pay dividends consistently.
• Value stocks have a low price-to-earnings (PE) ratio and are cheaper to buy than stocks with a higher PE. Value stocks may be growth or income stocks, and their low PE ratio may reflect the fact that they have fallen out of favor with investors for some reason.
• Blue-chip stocks are shares in large, well-known companies with a solid history of growth. They generally pay dividends.

How do stocks and bonds interact?  

The bond market and stock market typically show a negative correlation, meaning as one goes up the other goes down. A bond is generally viewed as a low-risk, low-return asset, while stocks are considered high-risk, high-return securities.  Investors' preferences for these investments fluctuate, so when investors turn to a safer bond market, bond demand increases and prices rise, leading to a decline in bond yields and lower stock prices as the demand for stocks decline. Investors may also leave the stock market if bond yields rise, which typically causes the stock market to decline. Occasionally, the correlation between stock and bond prices turns positive over the short term, typically in response to supply-side economic shocks or when inflation exceeds central bank targets.

Other factors that influence the relationship:

• Interest rates: Interest rates have a strong effect on bond prices. The effective yield of a bond is reduced when investors could achieve close to the same profit without paying for a bond as interest rates rise. Thus, bond prices fall when interest rates rise, and rise when interest rates fall. At the same time, interest rate changes may or may not have a strong effect on the stock market. In theory, falling interest rates will push stock prices up since lower interest rates allow consumers to spend more and companies to borrow money to expand, while rising interest rates constrict the economy, causing stock prices to fall.  While the bond and stock markets typically respond similarly to interest rate changes, other factors such as investor sentiment, a strong or poor earnings season, or a multitude of other factors may impact the stock market. Therefore, it can be difficult to predict whether the bond and stock markets will move in the same direction in response to an interest rate change.

• Inflation: Whether the economy is forecast to grow or contract can also affect the relationship between bonds and stocks. Economic growth is typically good for stocks, since it leads to rising prices and increased income growth that pushes stock prices up and encourages investors to jump into the market. However, economic growth carries the risk of inflation, which reduces the value of a bond's fixed interest payments and compensation. Thus, forecasted economic growth can cause stock prices to rise as bond prices fall.

Why is the relationship between stocks and bonds important?

The relationship between stocks and bonds can have a significant impact on the diversification of your portfolio. If you are investing in bonds to offset weak economic growth and mitigate stock market volatility, you will want the market to reflect a negative stock-bond correlation, which will strengthen your portfolio diversification. Most recently, with the onset of COVID-19, the market shifted from a negative correlation to a positive correlation as the Federal Reserve instituted aggressive monetary tightening. Though initially seen as a positive milestone, 2022 – with a 25% decrease in stock prices and a 17% drop in Treasury bonds – reminded us that a negative correlation is more favorable for shoring up risk in our portfolios.

If you have concerns about your investments, Robbins LLP offers Stock Watch, a free investment monitoring service for anyone interested in ensuring corporate fiduciaries are properly managing their corporate assets.

Investing involves risks, and no investment strategy can guarantee success. The information provided here is for general purposes and should not be considered as legal, financial, or investment advice. If you are interested in putting your retirement plan in order you should seek the advice of a certified financial advisor.