Are the interest rates paid on government and corporate bonds correlated to returns on shares (stock markets)?

17 February 2022

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Question by Grant

Are the interest rates paid on government and corporate bonds correlated to returns on shares (stock markets)?

Answered by Boring Money

Hello Grant,

If I understand your question correctly you are asking whether the interest rates paid on government and corporate bonds are correlated to returns on shares (stock markets).

There isn't a direct link between the two but external forces will affect both types of assets. Bonds and shares are said to be uncorrelated, that is their returns tend to go in the opposite direction. If stock markets are going up, the price of bonds fall. This is down to supply and demand; when stock markets are rising investors want to benefit from gains so demand increases and therefore so do share prices.

The consequence for bonds is that they become less popular so demand, and therefore the price falls. This cycle continues until such a time that stock markets become overheated or an event like a global pandemic spooks the markets and investors no longer want their money to be exposed to such risks. The cycle then reverses; demand and therefore stock market prices fall and investor money moves to safer assets like bonds, which increases the price.

It can't be said that bonds and shares are perfectly uncorrelated because they can go up and down together (the Credit Crunch was a good example when all major assets fell in demand and therefore price), but the range of returns for shares are much wider than for bonds.

I have referenced the price of bonds above because there are two elements that investors benefit from; capital growth if the price a bond is sold at is lower than the price paid for it (and vice versa) and the interest rate received while holding it. If you were to buy a government bond issue at outset and held it to maturity you would receive the interest rate offered and your capital back but most investors invest in bond funds in which bonds are traded on the bond market, which is where the capital return element comes in.

The greatest influence of bond interest rates and price is the change in the base rate set by central banks such as the Bank of England. If base rates increase (or are expected to increase) future bonds issued by governments and companies will have to be higher to be attractive to investors. Therefore any bonds in existence are less attractive because the interest rates paid are lower than could be received for new issues, therefore demand for them falls and so does the price.

The central banks set interest rates based on inflation expectations. Their role is to keep inflation at a sensible level to allow the economy to grow. Inflation that is too high means consumers and companies don't have spare income to spend on goods and services. Too low (or deflationary) and consumers put off spending because they aren't earning enough from wage growth or they delay buying things if they believe they will be cheaper in the future. The Bank of England is set a 2% annual inflation target.

As savers and investors, we want our money to grow in real terms (i.e. above inflation) so that we can maintain our purchasing power. Stock market investing offers the greatest long-term above-inflation returns but comes with short-term risks and do fall when inflation picks up. This is what we have been experiencing over the past couple of months or so. In periods of high, or expected higher, inflation the revenue expectations for companies fall because expected demand for their products and services fall (because there is less discretionary money in consumers' wallets when prices are higher and the cost of servicing debts increases following base rate rises). Companies also find their costs increase in an inflationary environment which reduces their profit if they are unable to pass all of the cost increases on.

I hope this answers your question satisfactorily. Let me know if not.


Answered by

Boring Money