How are bond yields and stock markets related?

“What are you reading so intently? Is it about equity markets again?” Pragati asked her friend, Shreyja

“Actually, I am reading about bonds and their relationship with stocks. How do bond yields affect the stock market? Why do bond yields rise when stocks fall? These are just a few questions I am trying to figure out,” Shreyja replied.

“Okay, but then why do you look so lost?”

“Because the relation between bond yields and stock markets is just as confusing as your and Arpit’s relationship was in college,” whines Shreyja.

“Not fair! The relation between bond yields and stock markets isn’t all that complicated,” declares Pragati.

“Care to enlighten me on bond yields vs stock prices, then?”

How do bond yields affect the stock market?

When you buy bonds, you are essentially lending money to the company or government that has issued the bond. In return, you receive coupons or interest payments, and these are termed as bond yields. Despite belonging to different asset classes, bonds and stocks share a relationship that has been seen time and again in the markets through bond yields and stock prices. Bond yields tend to rise when stock prices fall. Let’s explore why this happens.

Why do bond yields rise when stocks fall?

To understand the relation between bond yields and stock prices, it’s important to first understand the relation between bond yields and bond prices. When bond yields rise, bond prices in the market fall. This is because investors would want to invest in newly issued bonds at higher interest rates and the demand for the old bonds with the lower yields falls, pushing down the price. Hence, bond yields and bond prices share an inverse relation.

When inflation is on the rise, the central bank applies contractionary monetary policy and raises interest rates. The central bank does so to make borrowing costlier and discourage spending. In such a situation, the stock markets are not left unimpacted. Rising interest rates impact the stock markets in two primary ways. First, as the bond yield increases, it makes bonds more attractive investment options than equity markets. If bond yield rises to a point that is close to or higher than the returns of stocks, investors will withdraw funds from their stock investments and flock to bonds.

The second impact is a little more subtle or indirect. In a rising interest rate environment, companies find it harder to pursue new projects to grow and expand as the cost of borrowing has gone up. They can either continue to borrow high-cost debt or pause their projects. Either way, their financials are impacted, which is reflected in their valuation and stock prices.

Bond yields and stock prices: Key takeaways

Bonds and stocks are two securities that do not move in tandem. As bond yields rise, the stock prices fall. This is because they fulfil different investor needs and carry different risks. Hence, economic factors impact each of them differently. Due to this, it’s essential to have a well-diversified portfolio with both debt and equity asset allocation.


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