Although bonds and equities are two different asset classes, there is potential for bond prices and yields to impact the performance of your equities, including the prices of ETFs and direct shares. This article will give a high-level overview of the relationship between these two asset classes and how they may potentially affect you.
What is a bond?
Bonds are a defensive asset that provides investors with a fixed source of income and aims to preserve the capital invested into these assets. They expose investors to less risk in comparison to shares or property and may be a valuable way to assist you to maintain a diverse portfolio.
How do bonds work?
When an individual invests in bonds, the money is lent to a company or government and in return investors receive regular income called coupon payments. If the bond is held until the date of maturity, the investor will receive the face value of the bond back. The face value refers to the amount payable by the company or government on maturity which may be different to the amount it trades for, called the market value.
Investors may be more inclined to choose bonds over other asset classes as it provides them with a stable and fixed income stream and are lower risk, and therefore are not as affected by market volatility. The amount of risk associated with a bond will be contingent on the issuer of the bond whereby a government bond is likely to be lower risk than a bond issued by a company, called a corporate bond.
What is the relationship between bond and equity markets?
At the end of 2020, the global bond market was worth over $123 trillion, which exceeded the value of the equities market which was valued at around $105 trillion in the same period. Therefore, it is plausible that movements in the prices of bonds may impact the value of other asset classes including equities as there are changes to the movement of money within the market.
Why have bond yields reduced in 2020 and 2021?
Due to the COVID 19 pandemic, central banks around the globe have increased their investment in bonds to ensure that the market remained liquid and to prevent from economies becoming stagnant. The implication of this was that bond prices increased as the demands for bonds remained high and consistent. The result of high bond prices is that the yield of these bonds is reduced, and thus has kept interest rates low around the world, which has also been seen in Australia through the low mortgage rates available to borrowers.
How will this impact the price of equities?
As a result of these low bond yields, investors have seen an increase in the yields of other assets including equities. This has been one of the contributors to the strong market performance over the last 18 months. Another implication of low-interest rates is that it enables companies to borrow funds at a lower price which has assisted many listed companies to grow and expand which is then passed onto shareholders through increased share prices and dividends.
How will a rise in bond yields impact equities?
An increase in the value of bond yields may impact the ability of listed companies to borrow capital and therefore may have put downward pressure on the value of these company’s shares as they are unable to grow as easily. This supports the market phenomenon that often stocks and bonds move in opposite directions.
How can I reduce the impact of these changes on my portfolio?
A key way to reduce the impact of price fluctuations in the market caused by changes to bonds and equities is to maintain a diversified portfolio. By increasing your exposure to a range of asset classes, both growth and defensive, you are likely to minimise the impact of a fall in one sector on the value of your investments as you are not completely exposed to those assets. This could include holding bonds, shares and ETFs across a range of sectors and industries in both domestic and international markets.
If you would like assistance in diversifying your investment portfolio or tailored guidance concerning your investment strategy, please click the link to organise a complimentary 20-minute phone call with an EPG Wealth adviser.