Prices of bonds and stocks are moving in tandem, shredding the long-held investment theory that when one rises, the other falls. Risks are different for bonds, for which the coupon payments are an issuer’s contractual obligation, than for common stocks that carry no promise of returns, but the two asset classes are behaving as though they’re one and the same.
This new relation of hand-in-hand movement of bonds and stocks has been driven by historically low interest rates approaching zero. The goal of central bank policy in pushing down interest rates is that very low returns on cash in bank accounts or bonds discourage saving and encourage spending.
A flood of money has poured into the bond market by central banks’ bond-buying programs, which have succeeded in rescuing COVID-19-ravaged economies. However, the policy has also wrecked the traditional relationship between stocks and bonds.
Low interest rate central bank policy has boosted the value of existing bonds with heftier coupon payments. In turn, money available with low interest rates has allowed companies to borrow more, buy back their shares at low cost and, as a result, with fewer shares, earnings per share have risen. That has boosted prices of stocks.
“Markets are not trading on economic fundamentals. Rather, they’re trading on government policy,” says Chris Kresic, head of fixed income and asset allocation as well asportfolio manager, fixed income, at Jarislowsky Fraser Ltd. in Toronto. “It’s unusual in that the [U.S. Federal Reserve Board] is aggressive on forward guidance. [The Fed has said] it will not interest raise rates for a few years, so that has made the bond market less sensitive to economic fundamentals. Bonds are now trading on government policy favouring cheap money.”
The Fed, the Bank of Canada and central banks in other G-7 countries want to pump up asset prices, especially those of stocks. Interest rates are down so the valuations of future corporate earnings – that’s earnings stream divided by interest rates – are up. “Asset revaluation based on falling bond interest is, therefore, positive for both stocks and bonds,” Mr. Kresic says.
Not only do low interest rates make it cheaper to borrow to build plants and produce goods, but future earnings of companies able to carry debt cheaply are also worth more today. Low interest rates reduce the discount for future money, including earnings. Thus, every company’s earnings stream is worth more. That alone can boost share prices.
Behind the positively correlated performance of stock prices and bond prices is the effect of low interest rates on corporate debt. It costs less to carry, so the income statements of companies with lots of bond debt and loans look better. As well, inflation is very low, and investors are taking comfort in the expectation that there’s no reason for interest rates to rise any time soon.
“The entire stream of future earnings and dividends is worth more when it costs less to carry,” says Sébastien Lavoie, chief economist at Laurentian Bank Securities in Montreal. In turn, stocks of companies with a lot of debt are worth more “The cost of money embedded in prevailing interest rates is about zero, so one can pay just about anything for future earnings.”
Ironically, low interest rates do not discourage investors from buying bonds.
“As stock prices soar, investors get nervous,” Mr. Kresic notes. “They can buy options to protect their downsides, but every option has an embedded cost. Options are insurance and insurance always costs something. But buying bonds as buffers for a potentially overvalued stock portfolio is cheaper than options. There’s no charge for bonds’ insurance other than low returns.”
Moreover, bonds pay their own costs and offer a profit if interest rates continue to fall and existing bonds rise in price.
Some stock profits will flow to bonds just by portfolio rebalancing. That process drives up bonds’ market prices even further. And that makes them even more efficient as self-financing portfolio insurance. It’s not making money on bonds that counts in this process, but managing risk by taking money in stocks off the table.
Low interest rates thus make investment-grade bonds more attractive as risk-management tools for portfolios, no matter that they pay little. Low interest rates also help highly-leveraged junk bonds. Their issuers’ hefty debt is cheaper to carry – just like investment-grade companies’ debt. Cheaper debt means less stressed balance sheets.
“The low returns on bonds and other debt also creates an incentive for investors to buy more equities,” says James Orlando, senior economist at TD Economics in Toronto. Thus, in the topsy-turvy world caused by depressed interest rates, investors are bidding up stock prices and bond prices together. Low interest rates make any earnings stream look better, any debt easier to carry and all corporate capital – that’s stocks and bonds – cheaper to finance. That’s why stocks and bonds behave as though they are one asset class driven by one variable – dropping interest rates. When interest rates rise, this marriage of former opposites is likely to end.