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Lesson in Course: Bonds (advanced, 9min )
I keep reading about bond yields in the news. What do I need to know if I only invest in stocks?
Investors often look at the U.S. Treasury yield as a barometer for future economic health. To review quickly, the U.S. Treasury borrows money for the Federal Government by issuing out bonds. The name of this debt (bills, notes, bonds) depends on the bond's duration. Investors worldwide buy U.S. Treasury debt as a safe way to park cash so that it earns a return—it's improbable the U.S. government will default.
Here is a quick introduction to bonds if we need it.
Out of the government's different debt, the 10-year Treasury gets a lot of attention because most consumer interest rates—like credit cards, auto loans, mortgage rates—are set based on the 10-year yield.
Historically, bonds and stock prices have an inverse relationship. When bond prices are going up, stocks are going down, and vice versa. The reason is that when investors are afraid or pessimistic about the future, they sell stocks and look for safer investments like bonds. The increased selling of stocks results in a drop in stock prices, and the increased bond buying results in increased bond prices.
The bond yield also has an inverse relationship with bond price. A bond’s yield is determined by dividing the coupon payment by the bond’s current price. Since the bond’s coupon payments are fixed, the bond’s yield will be higher when the price of the bond goes down and the yield will fall when the price rises.
Bond yields and stock prices typically move in the same direction since they both move in the opposite direction of the bond prices. Check out this short video below.
Sometimes the bond yields may spike quickly which destabilizes the stock market. In many cases, a rapidly rising 10-year Treasury yield (blue) causes stocks to drop (red).
Some reasons folks use to justify the drop in stock prices include:
Historically, stock prices recover when the spike in yields settles. Our Central Bank, The Federal Reserve, is in charge of preventing yields from spiking.
While it’s important to keep track of what’s happening in the bond markets, it’s difficult to take advantage of rapid changes. Proper diversification will help soften any blow to your portfolio. However, in almost all cases stocks usually rebound shortly after, so the best action could be to do nothing or buy the dip (buy when the price drops).
A bond’s yield is determined by dividing the coupon payment by the bond’s current price. Since the bond’s coupon payments are fixed, the bond’s yield will be higher when the price of the bond goes down and the yield will fall when the price rises.
A coupon rate is the interest rate that the bond promises to pay every year. For example, a $100 bond issued that pays $5 in interest a year has a coupon rate of 5%.