What ties stocks and bonds together?

Julie Brownlee, Fsp Invest, 02 Jun. 2014

Tags: stocks and bonds, stocks, shares, bonds, interest rates, markets, low interest rates, high interest rates, investing

You may not have thought about this before, or realised it, but there’s a link between the stock market and the bond market. But why is there a connection between them? And why should you care? Let’s take a closer look…

The one thing that links stocks and bonds

There’s an indisputable relationship between stocks and bonds. And there’s one big reason why you should remember their relationship.

It all boils down to interest rates, Shah Gilani in Money Morning explains. Here’s why…

In effect shares and bonds are substitutes for each other.

You can buy a share hoping its share price will rise. Or you can buy a share for its dividend yield and hoping its share price will rise.

Or you could take that money and buy a bond instead.

Not only that, bonds (which are interest rates) are part of the valuation of any share equation.

Think about when you trade single stock futures and contracts for difference and other derivatives. You trade on margin.

What happens when interest rates rise?

This trading on margin gives you leverage. There’s an interest cost to a margin. If interest rates are higher, then this will cost more. The higher interest rates are, the higher these carrying costs are.

If interest rates rise, bonds can become a more attractive proposition.

Rising interest rates also affect companies you invest in. Higher rates increases their cost of money. They’ll have to pay more to service their debt. And higher rates may also affect the products and services they offer to their customers.

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Low interest rates makes stocks more attractive

The financial crisis led to interest rates coming down to historic lows. This led to stocks becoming more attractive.

What drove this change? The fact that investors could get a better dividend yield from shares than from interest elsewhere. If interest rates rise, these dividend yields won’t be as attractive any more.

So there you have it, why interest rates tie stocks and bonds together.

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