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Understanding Low Bond Yields
Low bond yields and interest rates are often credited with supporting higher prices in the stock market. That’s because lower bond yields can make the potentially higher yields offered by stocks more attractive to investors.
In addition, lower bond yields imply lower interest rates, which reduce the borrowing costs of companies. Lower costs to borrow can contribute to better corporate profitability. In such instances, investors may move money into the stock market, pushing stock prices higher.
Correspondingly, lower bond yields can indicate a better economic environment and greater prospects for business growth. So investors often move their money into stocks because a need for relatively risk-free (lower yielding) Treasuries no longer exists.
Until the U.S. Federal Reserve started raising interest rates to fight high inflation in 2022, bond yields had been consistently low since 2009. And they’d been dropping since the 1980s.
Key Takeaways
- Until 2022 when the Fed started raising interest rates to fight inflation, bond yields had hovered in a consistently low range since 2009, which contributed to the stock market’s rise.
- Low bond yields cause investors to look to stocks for higher yields.
- During economic slowdowns, bond yields drop as investors buy bonds for safety reasons.
- During economic expansions, stock prices usually outperform bond prices.
- Investors naturally demand higher yields from organizations that are more likely to default on their bonds.
Low Bond Yields Mean Higher Stock Prices
Interest rates are the most significant factor in determining bond yields, and they play an influential role in the stock market.
Generally, when rates are low and growth can proceed unhindered, the stock market appears more attractive to investors and demand drives up prices.
When bond yields remain low, investors look to stocks for better returns, especially when they feel confident about the economy and corporate profits.
Low bond yields often take hold during an economic slowdown because of the flight to quality by investors. It’s at such times that investors seek to preserve principal and reduce the risk of loss in their portfolios by buying bonds.
Central banks are committed to low interest rates to stimulate the economy during recessions. This lasts until the economy begins to grow without the aid of monetary policy or capacity utilization reaches maximum levels where inflation becomes a threat.
Economic growth also carries with it inflation risk, which erodes the value of bonds.
Inflation and Low Yields
Bond yields move according to expectations for inflation, economic growth, default probabilities, and duration.
A bond pays a fixed amount based on its coupon rate. That payment/amount never changes (unless the issuer defaults).
A decrease in the inflation rate raises the real yield of the bond. The real yield is the nominal yield, or coupon rate, less the rate of inflation.
For instance if a nominal yield is 7% and the inflation rate is 3%, the real yield is 4% (7% – 3%). As inflation drops the real yield increases. So lower inflation can make bonds more attractive to investors, and that could draw money from stock investments.
As the demand for bonds increases, bond prices rise and yields decrease. That results in lower nominal yields, which could then make stocks more attractive.
Inflation fell persistently (with some intermittent increases) between 1980 and 2020. Lower expectations for growth and inflation meant that bond yields remained constantly low (and prices high).
But an economic expansion beginning in 2021 started pushing inflation rates higher. The Fed intervened in 2022 to raise interest rates to reduce the rate of inflation. This raised bond yields.
Bear in mind that when interest rates/yields rise, bond prices drop. When they fall, prices rise.
Growth and the Stock Market
During periods of economic expansion, bond prices and the stock market can move in opposite directions because they are competing for capital.
On the one hand, selling stocks and buying bonds leads to higher bond prices and lower yields.
On the other, stock market rallies tend to raise yields as money moves from the relative safety of the bond market to riskier stocks with potentially higher returns.
When optimism about the economy increases, investors tend to transfer funds into the stock market because it may offer investors greater financial benefit from economic growth.
During most of the first 20 years of the 21st century, bond and stock prices moved in opposite directions. Bonds provided investors a hedge should stock prices drop. But when the Fed began raising interest rates in 2022 to counter inflation, bond and stock prices moved in the same direction, eliminating that hedge.
Default Risk and Bond Yields
The probability of default also has an impact on bond yields. When a government or corporation cannot afford to make bond payments, it defaults on the bonds. Investors naturally demand higher yields from organizations that are more likely to default.
Federal government bonds are generally considered to be free of default risk in a fiat money system. When corporate bond default risk increases, many investors move out of corporate bonds and into the safety of government bonds. That means corporate bond prices fall, so corporate bond yields rise.
High-yield (junk) bonds have the highest default risk, and default expectations have more influence on their prices.
During the 2008 financial crisis, default expectations for many companies rose significantly. As a result, corporate bonds temporarily offered higher yields.
What Do High Bond Yields Mean for the Stock Market?
They make bonds more attractive to some investors, who may pull money from the stock market to invest in bonds. Or investors may put as yet uninvested funds into bonds. The consequence is lower demand for stocks and lower share prices.
How Does Rising Inflation Affect Bond Yields?
Rising inflation can reduce the purchasing power of the income that bonds provide. During periods of rising inflation, the real yield (coupon yield minus inflation rate) for investors decreases. In addition, if the central bank intervenes to raise rates to fight inflation, bond prices can fall as bond yields rise. This can reduce a bond investor’s total return (which is partially based on how much they sell their bond for compared to the purchase price).
Should I Invest in Both Stocks and Bonds?
Broadly speaking, yes. How much money you allocate to each may depend on your age, financial needs, and investment goals. But diversifying your portfolio with different types of investments is an important way to reduce your overall risk of loss.
The Bottom Line
For investors, low bond yields can make the stock market a better investment due to perceived higher returns.
Constantly low bond yields can cause investors to move money out of bonds and into stocks. This increased demand for stocks pushes share prices up.
