Successful share market investors will also keep an eye on bond yields. This is because it is an indication on how investors perceive the economy. Yields on US treasury bonds have recently fallen to historical lows, so what does this say about how investors perceive the state of the economy?
Bond prices and bond yields move in opposite directions. When investors flock to take positions in bonds, this causes bond prices to rise as demand increases. However, it also causes the bond yield to decrease.
How do bond work?
Bonds are usually issued in denominations of $1000 known as the par. Bond prices are quoted in percentage terms so this is expressed as 100 or at par. The bond yield is the amount of income an investor receives on a bond.
If a 10-year bond is issued with a 5 percent interest rate (bond coupon) and interest rates go up, then this 5 per cent interest rate bond holder will struggle to sell it in the market as there are other bonds offering higher yields. For example, a 6 percent coupon. To compensate for this, the 5 per cent bond holder will need to lower their bond price to make up for the difference in loss for the 1 percent interest rate coupon loss.
If interest rates drop, then this 5 per cent bond coupon becomes more attractive as newer issued bonds may have, say, a coupon rate of 4 percent. In this scenario the owner of this 5 per cent bond coupon can increase the bond price as it would be in higher demand than the newer issued ones of 4 per cent. Therefore, there is an inverse relationship between bond prices and interest rates.
Why are investors flocking to bonds?
Selling in the stock market can lead to higher bond prices and lower bond yields as money moves into the bond market. Investors are worried about the coronavirus pandemic and the impact it will have on the economy. Hence, they are investing in safe havens such as bonds, driving prices up and bond yields down.
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Investors should consider diversifying their portfolio as analysts are predicting another rate cut from the fed which means bond yields will go down even further. Despite the stock market volatility, there are still defensive sectors where investors can invest with lower risk but may generate returns higher than bonds. If investors have their funds concentrated in safe but low yielding asset classes, they will lose out in returns when the share market bounces back again once fears of the coronavirus subside.
Lauren Hua is a private client adviser at Fairmont Equities.
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