Bonds play a crucial role in the money markets because it is one of the so-called ‘more stable’ investments.
Bonds and stocks move in the same direction
One of the main reasons why bonds affect the stock market so much is because they are both investment methods. This means that they both want the investor’s money although they can work in different ways. However, in its own ways, both are directly correlated.
Opposite sides but of the same coin
In the investors’ eyes, bonds are often perceived as safer and more stable. However, the natural effect here is that the returns are lower. This means that if the value of stocks go up, the value for bonds will go the other way. In other words, when the economy is strong, booming and very stable:
- Stocks will do very well
- Consumers are actively buying in the economy
- Companies and businesses are booming and profiting because of the demand
- Investor confidence would be high
- This will prompt many to start buying stocks (to beat inflation) and sell their bonds
On the other hand, when the economy is sluggish and slowing:
- Consumers do not buy as much which means businesses are not profiting as much as they like
- Corporate profits start to decrease
- Stock prices are dropping as a result
- Investors start wanting regular interest payments which are guaranteed through bonds
When both prices increase
It is not absolute that the price of bonds and stocks always go opposite directions. There are situations when they can both increase simultaneously. This can happen when there is:
- Too much money
- Too few investments
- Investors are overconfident while others are not
When both prices decrease
On the other hand, it could happen the other way as well. that is when investors are in a frantic selling stage as they panic. That will push gold prices up which will cause both prices of bonds and shares to drop.
How do they work exactly?
On one end, bonds are typically loans. This is the type of loan which you make to a larger and more stable organization. It could be a corporation and would usually be the government. As such, you can be guaranteed of returns as the interest is the same for as long as the loan is active. If the firm does not default, you will get the principal amount at the end of the term. It must be noted though that the value of bonds will change but it will only affect you if you want to sell it. The return of bonds is known as yield.
On the other hand, stocks are shares. Typically, it is what shareholders hold which gives them a part of the voice in that company. The value of shares is dependent on the corporate earnings of the company. This is usually released as financial reports in quarters. Unlike bonds, the value of shares is a lot more volatile. It changes each day (or could be by minutes).
So how do bonds affect the investor?
The main factor that can affect the decision of the investor is the goal. Go for bonds if:
- You want regular payments
- You do not want to be affected by inflation
- Avoid losing your principal
- You are not in need of quick cash
On the other hand, if you are one who can outpace inflation, then you might want to go for stocks. This includes not being moved when the value of stock drops.
It makes perfect sense to have a diversified investment strategy. You should have a mixture of bonds and other investments. This is like having a stable job which does not pay very well and a part-time or side-income that pays better but is not consistent. This can only be possible if you know how the economy is doing. For shares, you need to know if the company is in the expanding stage which will help you decide to go big or to lay low.