What is the correlation between bond and equity prices?
1 Answer
It is said that-"Stock prices and bond prices should move in the same direction.” Most traders believe that bonds are a direct substitute for stocks and are used as a flight to safety in times of trouble.This is partly true.At the time of crisis,bonds stands as a safer investment than equities.
Bond prices are inversely related to their interest yield. If rates in general go up, then someone selling a bond in the secondary market with a lower rate must drop their price to make the overall yield for the bond comparable to new offerings with higher coupon rates.If the rates in the market go down, then someone can sell their bond for more money if it offers a higher rate than what is now available.
This higher rate of return is a larger burden on their balance sheets and causes less profitability and therefore, lower EPS. Couple that with higher borrowing rates for business and the consumer alike and you will start to see a slowdown in business. That slowdown will result in the liquidation of share holdings in search of better investments.
Businesses compete for investor money and also offer corporate debt (bonds) to finance operations. A rise in bond buying will cause the prices to rise and interest rates to fall. This allows for further expansion and consumption in business and a bull market for stocks. Due to this relationship, bond prices and stock prices should move in tandem in the long-term, with mild interruptions in the relationship at turning points. In fact, these divergences can be used as an indication of probable turns in the equities market.
Thus,bond prices and stock prices should move inversely.
