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Bonds yields up, shares up ... or is it shares down?

The world’s bond markets and stock markets not only attract vast sums of money, but also a lot of financial commentary in newsletters and newspapers.

In many of those commentaries, there’s a presumption that both bonds and stocks should always trade in an overtly consistent and predictable manner – stronger economic growth means higher yields and higher share prices, while slower growth means the opposite.

When this doesn’t happen, analysts often fall over themselves to argue that one market is ‘right’ and that investors in the other should be paying more attention. Even without the overlay of a titanic clash, analysts are prone to discuss contrary price action in the markets as if they’re responding with different mindsets.

I saw an example of this recently in the Australian Financial Review. It was an article mostly about US bond yields, which were said to be falling because of concerns that COVID and expected tighter policy were combining to reduce the economic growth outlook. However, it finished with the following statement:

“Equity markets appear decidedly more upbeat than the bond market … The S&P 500 reclaimed a record high on Monday and the S&P/ASX 200 Index hit a fresh peak on Tuesday.”

However, bonds and shares are two very different asset classes, so why should they trade in a correlated fashion? Standard portfolio optimisation theory relies on different asset classes being uncorrelated, otherwise the eggs aren’t being placed in different baskets.

What’s going on here?

Correlation history

A clue can be found in the history of the correlation between these markets. From here on I’m focused on the US which dominates daily trading in all markets.

In recent history, we find that there has actually tended to be a positive correlation. That is, yields and stock prices move together in the same direction.

The following chart shows the rolling 100-day correlation of daily changes in 10-year US Treasury yields and the S&P500 index since 1980. Clearly, for just over half of the last 40 years, the correlation was negative. Then from 1998 until 2007, the correlation fluctuated quite markedly perhaps with a slight positive bias but nothing significant.

Since 2007, however, the correlation has been positive and, to be honest, that makes it look like the last four decades can be split in half – 20 years of negative correlation then a shift to generally positive for the last 20 years. That’s certainly sufficient evidence to convince a lot of people that, right now, stocks and bonds should be expected to trade in the same direction most of the time.

Source: Bloomberg, Federal Reserve Bank of St Louis

However, I suggest that just because there’s been a positive correlation so far in the 21st century, that doesn’t mean that it’s going to stay that way.

Taking a longer-term view shows that the recent period is actually a rarity. In an excellent paper written in 2014, Ewan Rankin and Muhummed Shah Idil of the Reserve Bank of Australia studied "A Century of Stock-Bond Correlations". They demonstrated that the short-term correlation between US stock and bond markets has always fluctuated considerably but has mostly been negative during the past 100 years.

The main exceptions were during recessions, when bond yields and share prices both fell, thus creating a positive correlation. It’s only since the GFC that this positive correlation has been evident for a prolonged period and they concluded that the current experience reflects the severe impact of the GFC on the uncertainty that surrounds expectations for economic growth.

That is, the market is behaving as if we’re in a recession, even when growth has been positive.

It's not a battle! Nature of the two asset classes

Even so, it’s incorrect to depict periods when the markets move in different directions as meaning that traders in one market have it ‘right’ and those in the other are ‘wrong’. It’s not a battle!

In reality, both bonds and shares are always responding to the same set of information in an appropriate way for the time, circumstances and nature of the asset class. Every time during my career that I've looked into what's going on there's usually a perfectly good explanation about why two different asset classes 'seem' to be moving in conflicting directions. Not always a simple explanation, but a good one.

That explanation is usually found in the different inputs to the valuation of different asset classes. Bonds have fixed income for a limited period of time, whereas shares are perpetual cash flow entities.

Bonds thus respond to changes in macroeconomic trends and central bank policy settings in a consistent manner: stronger growth = tighter policy = higher yields, and vice versa. Note, however, that even within the bond market, not all securities respond identically. The yield curve is not constant, as long-term and short-term bonds can respond to different degrees to the same cash rate change. The curve tends to steepen during periods of falling cash rates and flatten when policy is being tightened.

So if different bonds react differently, why should we expect a different asset class to behave itself?

Shares factor these same changes into their valuations in a more complex manner. Changing bond yields feed into the discount rate for valuing earnings, but unlike bonds the earnings of shares can also vary. So sometimes when bond yields are rising share prices will also rise because there’s a stronger economy driving better earnings growth, but sometimes shares will fall because of the higher discount rate.

There can also be other factors at play. Sometimes, stock markets might validly look at profit-enhancing micro trends when the bond market is looking at the macro consequences.

Finally, there can be timing differences because the behaviour of each market is part of the information that the other market needs to price in. The main players in bond markets are more closely watching short-term data trends and predicting the central bank's next move more closely than company analysts.

Once bond yields fall, then that is sometimes the signal to equity market participants to shift their behaviour too. But the bond market doesn't always get its central bank calls right, so stock market players have an appropriate natural wariness about reacting instantly to what the bond market is doing. And bond market traders need to respect the stock market’s direction as well.


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Conclusion

The idea of a tussle between stocks and bonds is often used by analysts to create a story and to sound impressive. In reality, both markets are reacting to the world in their own way rather than being engaged in a struggle for supremacy.

When these markets move in different directions, it’s always worth digging a little deeper to understand the dynamic that’s playing out between what are two different types of assets. Both markets are usually ‘right’ (if there is such a thing) and I prefer to think of it as being more of a dance than a battle.

 

Warren Bird has 40 years experience in public service, business leadership and investment management. He currently serves as an Independent Member of the GESB Investment Committee and was, until recently, the Executive Director of Uniting Financial Services, one of Australia's oldest ethical and ESG fund managers. This article is general information.

 

9 Comments
CC
August 22, 2021

but isn't there a difference between fixed rate bonds and floating rate bonds ?
the former should do very poorly as interest rates rise, but not the latter...

Warren Bird
August 23, 2021

Hi CC,

OK, this is getting a little technical and perhaps nit picking. In my world, I don't speak of floating rate notes as 'bonds'. A lot of folk do, and they're not wrong because the issuer of a floater is obligated - or bonded - to pay interest and repay capital at maturity, as opposed to shares where it's a wish and a prayer whether you ever get any money back from the company that raises equity capital.*

However, my article only had in mind the fixed rate securities issued by governments - US Treasuries in particular - since that's what the media and other commentaries to which I was responding were referring.

But since you mention them, let me make a few comments about floating rate notes (or FRNs).

The first thing is that folk need to be clear that FRN's do have a fixed element to the income they pay, which is related to the credit risk of the issuer. They have a floating component linked to the cash rate or a money market rate, plus a fixed margin over that. This fixed margin results in short term capital price fluctuations when the market level for that margin changes.

In turn, this can create a positive correlation between their performance and that of stocks. When the stock market falls, credit spreads usually widen, producing a short term negative impact on FRN values. I only mention that so that we're clear that FRN's are not free of a similar risk of short term adverse price movement to that which bonds experience. Sometimes I get the impression that a lot of investors have been sold FRN's on the basis that they don't have the same price risk that bonds do - that's simply not true.

BTW, I don't advocate most investors using government bonds to diversify (see my article on this here:
https://www.firstlinks.com.au/response-government-bonds), but they will do a better job of it than FRNs when the stock market does really poorly. We saw a couple of extreme examples of that in the aftermath of 9/11 (wow, approaching the 20th anniversary of that event now!) and the GFC (2007-08 and into 2009) and, more recently, at the start of the COVID outbreak in March 2020. Those periods show up as very high positive correlations in my analysis because government bond yields fell sharply at the same time as share prices fell sharply - meaning that government bond returns were positive at the time of negative share returns, providing diversification. But in those periods, FRNs did relatively poorly because the credit linked element of their interest payment was also revalued down. You only have to look at any of the FRN ETFs or the Bloomberg Australian floating rate index (BAFRN0) to see the sharp downwards blip early in 2020.

So, yes, to your comment, if interest rates rise then bonds will provide a short term negative return whereas FRNs will usually be positive at that time. Unless there's also a widening of credit spreads at the same time in which case FRNs may not do quite as well as you think. Just as the relationship between bonds and shares is complex, not simply and predictable, so there are nuances between how fixed rate bonds and FRNs can perform, particularly at times of market stress.

* was being a little facetious there, but it's strictly speaking the truth that equity capital is raised on a best endeavours basis with no promise about how much return will be generated.

Phil Kennon
August 18, 2021

Hi Warren, I find the terminology confusing. To me, when investors sell bonds (bond prices fall, bond yields rise, "risk on"), and buy shares (share price rise, "risk off") that's a negative correlation, not positive. That negative correlation is what generally happens and that's why, for example, Industry Fund portfolios like My Super have Balanced portfolios with growth assets like shares balanced off by defensive assets like bonds because their values generally move in opposite directions.

Warren Bird
August 18, 2021

Hi Phil, of course, it can be measured in both ways. You're talking about a positive or negative correlation of short term returns, which is what most portfolio theory and portfolio construction focuses on.

I could have taken that approach as well, but because I was reacting to typical media commentary I was operating within that paradigm which tends to talk about yield movements and share price movements. Also, the RBA paper that I referred to studied the history of bond yield and share price correlations, not bond and share market returns.

It's just as valid as the other, especially for the point that I was mostly trying to make about how the two assets are not in conflict with one 'right' and the other 'wrong'.

One clarification though about your use of risk on and off. The scenario you depicted - selling bonds to buy shares - would be risk on. It involves selling the low risk asset to buy the high risk asset. It's not that one leg is risk on and the other risk off, it's the combination that determines the risk appetite of the transaction.

Hope that helps.

Phil Kennon
August 18, 2021

Good pick up Warren, buying shares is risk ON. Just testing you there!

Warren Bird
August 19, 2021

Hi again Phil, Steve Miller's article this week continues the theme and uses return correlations. Check it out:

https://www.firstlinks.com.au/us-rate-rises-challenge-diversified-portfolios

Allan Cross
August 15, 2021

I think I understand the concept that when new bonds are issued at a higher or lower yield than previous issues it means that the marketable value of the previous issues change. What I don't get is how that effects the bond ETF's, managed funds etc. Given that an ordinary small investor such as myself can't afford to buy the size of blocks of bonds that are issued, I know of no other way to invest in them, so it would help if the effects could be explained please.

Warren Bird
August 17, 2021

Hi Allan
it's not just new bond issues that result in the market value of existing bonds changing. In fact, the causality works the other way.
Bonds are trading all the time. One fund manager is buying, another is selling, they go through an intermediary investment bank and the yield at which they exchange the bond is - at least for that moment in time - the market level for the yield and price of that bond.
Then when a bond issuer comes to the market to raise funds through a new bond (this is called the primary market), market forces will mean that this new bond has to be priced to yield the same as existing bonds of similar maturity and issue quality. (In reality, new bonds are often of a different maturity to existing bonds and the yield needs to be interpolated between existing bonds either side of the maturity of the new bond.) The point is that it's the secondary market sets the pricing for the primary market, not the other way around.
How it affects ETF's and managed funds is that all the existing bonds that are held in those vehicles need to be repriced daily at the market rate. Otherwise savvy people could buy or sell units in the managed fund at the wrong price, which costs all other holders of the vehicle because the value of what they're left with is reduced by the difference. So, to be fair to everyone, all buying and selling in an ETF or managed fund has to be done at the market rate at the time of the transaction.
I've written a few articles over the years that go into some of these things in more detail. Maybe you'd like to check out:
https://www.firstlinks.com.au/term-deposit-investors-did-not-understand-the-risk
https://www.firstlinks.com.au/idiots-guide-bond-funds
https://www.firstlinks.com.au/differences-direct-bond-funds
https://www.firstlinks.com.au/journey-life-fixed-rate-bond
https://www.firstlinks.com.au/bond-questions-answered

All the best. BTW I fully endorse your decision to use ETFs and managed funds for bond exposure! You need a portfolio, not just a couple of bonds, and the only way - even for personal investors with large sums of money - to do that well is through pooled vehicles. Personally that's how I do it!

George
August 12, 2021

Thanks, Warren, I've always wondered why commentators think bonds and stocks should react to the same factors when they are different assets.

 

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