The tea leaf of stock investing could be in the underlying corporate bond yields, which tend to have a high predictability rate in the company’s future stock performance going forward.
Seasoned stock investors know to keep bond yields on their radar.
“Seasoned stock investors know to keep bond yields on their radar”
To understand how bond yields impact stock prices let’s first define what is a bond
A corporate bond is a type of debt security that is issued by a firm and sold to investors on the bond market. So, the bond market connects corporations with capital for expansion and bond investors with regular fixed income, which is why the bond market is also called the fixed income market, Moreover, when the bond expires, or “reaches maturity” the payments cease, and the original investment is returned, provided that the corporation or government issuing the bond remain solvent and doesn’t default.
So, when companies issue debt, it is called corporate bonds which provides bond yields.
Governments also issue bonds. For example, treasuries are issued by the US Department of the Treasury and gilts are UK Government securities issued by HM Treasury.
Treasuries, gilts, and corporate bonds all have the following in common, they have a maturity date, pay yields, and have a credit rating
“the bond market connects corporations with capital for expansion and bond investors with regular fixed income”
But what factors influence bond yields?
Bond yields are determined in the bond market. So, let’s say Apple decides to issue a bond with attractive yields, investment demand is lightly to be strong, bearing in mind the company has a strong balance sheet with good fundaments. So as demand for the bond increase it also pushes up the price of the bond and its corresponding yields down. Note the opposite relationship or inverse relationship between the price of a bond and its corresponding yields. In short, buoyant demand for bonds driven by upbeat microeconomic factors can push bond yields lower and vice versa.
Moreover, macroeconomic factors relating to GDP, inflation, unemployment can also influence central bank monetary policy, as we are seen over the last decade the US Federal Reserve has implemented the greatest monetary easing experiment in the history of finance. Zero or near-zero interest rate policy ZIRP and 120 billion US dollars of asset purchases per month, known as quantitative easing QE are suppressing the 10-year treasury yields.
In other words, the Fed’s QE is the yield control tool in the central bank’s monetary policy tool kit.
“The world’s negative-yielding debt pile hits an $18 trillion record at the end of 2020” – Win Investing
Bond investing can provide investors with passive income, in the form of bond yields and relatively low risk compared with stocks, which is a riskier asset class.
Bond investors typically receive the principal sum invested on the bond’s maturity, provided that the issuer remains solvent and doesn’t default.
In the worst-case scenario, the bond issuer becomes insolvent bond investors have priority over stock investors in a bankruptcy situation.
Secured debt is the first inline to get paid when a corporation is made bankrupt and there is a fire sale with stocks way down the list, often left holding the bag, losing the entire amounted invested in stocks if the corporation is declared bankrupt.
But with financial markets so financialized in the age of monetary accommodation which is taking the form of yield curve control, bond investing, while less risky than stock investing is losing its appeal.
Put simply many bond yields have fallen into negative territory when factoring in real inflation
The world’s negative-yielding debt pile hits an $18 trillion record at the end of 2020.
So pitiful bond yields which don’t even keep up with real inflation have persuaded conservative investors, pension funds to dip their toes deeper into riskier assets, such as stocks.
Forced optimism has been financially engineered in an environment where there is no real alternative, TINA.
Credit rating agencies can also have an impact on bond yields.
Credit rating agencies (CRA, also called a rating service) assign credit ratings, which rate a debtor’s ability to pay back debt by making timely principal and interest payments and the likelihood of default.
The “Big Three” credit rating agencies controlling approximately 95% of the rating business are Moody’s Investors Service and Standard & Poor’s (S&P) together control 80% of the global market, and Fitch Ratings which controls a further 15%. Tripple AAA is the top rating representing the lowest probability of default risk while CC and D credit score represent junk grade, high probability of default, insolvency.
So, when a bond investment grade is downgraded by a credit rating agency, the bond becomes less attractive to investors, demand for the bond falls putting downward pressure on its price and its corresponding bond yields rise. The riskier the investment the greater reward the investors demand.
“if the stock price of a company is falling and there is a rumor that the company is experiencing financial difficulties just tune into corporate bond yields” – Win Investing
The takeaway of this piece is that bond yields directly impact stock prices
So, stock investors shouldn’t worry about short-term stock price movements, which are often noise but rather focus more on the fixed income market, particularly bond yields.
Stock investors may recall in March how the rising treasury ten-year yield triggered a sell-off in growth stocks into value.
When the treasury ten-year yields rise that impacts the cost of borrowing, particularly mortgages. In other words, the rising ten-year treasury yield is a headwind on the economy, since it increases the burden on households and businesses to service long-term debt.
Conversely, when bond yields fall that is a bullish for stock investors. So, if the stock price of a company is falling and there is a rumor that the company is experiencing financial difficulties just tune into corporate bond yields. If the bond yield for the company is stable or falling, chances are that the rumor is false.
Taking this full circle as a stock investor you are likely to have several stock indicators and corporate bond yields should be one of them featuring on your radar
If capital flows show no signs of stress in the bond market and yields remain stable or low then bond investors, who tend to be closer to the business, are not nervous, so neither should you be as a stock investor.