When investing people typically look at stocks versus bonds, as distinct investment alternatives. However, oftentimes what is going on in the bond market can have a significant impact on the stock market.
The most obvious case of bonds having an effect on stocks is when there is a change in interest rates. In theory lower interest rates are positive for stocks, since a value of a firm increases when rates are lower, assuming dividends and profits remain constant. However, stocks in recent years have oftentimes not done well when interest rates dropped because there has been a perception that business conditions are weakening.
When people look at interest rates, it is typically U.S. Treasury yields that are being referenced. U.S. Treasuries are normally the safest of bond investments because they are backed by the U.S. government, which has the ability to print money. In addition mortgage rates normally track quite closely to changes in the 10 year Treasury yield.
What investors often don’t realize is that interest rates for different bond investments don’t always move together when yields for U.S. Treasuries change. Besides U.S. Treasuries, the other main categories of fixed income investing are municipal and corporate bonds.
Municipal bonds are issued by states and localities and are tax free. Because of their tax free statues their yields are normally less than U.S. Treasuries. However, there are times when certain municipal bonds may yield more than U.S. Treasuries. This is true, if a particular state is experiencing
Corporate bonds are issued by businesses to finance their activities. Therefore, for investors in the stock market, what is occurring in the corporate bond market is more significant compared to municipal bonds and U.S. Treasuries.
A term that is frequently used among corporate bond investors is “spread”. Spread reflects how much more a corporate bond yields versus a U.S. Treasury. When financial markets are calm the spread might be 1% point for a high quality bond. That means for a Treasury that yields 2% with a 10 year maturity, a corporate bond for the same maturity would yield 3%.
When markets become stressful these spreads tend to widen. During the severe recession in 2008 corporate spreads widened to about 5% points. This meant that accessing new capital for businesses became very expensive, and explains why the stock market was performing very poorly despite low Treasury yields.
Toward the end of September spreads for high-grade corporate bonds had widened to about 1.6%, though they have narrowed modestly recently. This explains some of the relative weakness that the stock market experienced in August and September was due to the widening of these spreads. However, relative to where spreads were in 2008, this was not that significant.
Besides the high-grade corporate bond market it is important to look at high yield bonds. The same way it is for consumers, that those with the best credit can borrow at the most favorable rates, it is also applicable to corporations. Those businesses with a riskier profile have to access credit through the high yield or “junk bond” market.
When business conditions are favorable, spreads in the junk bond market contract. At the end of 2013 spreads in the junk bond market were just under 4%. At the end of September spreads had widened to nearly 6%, though they have contracted some since then. During the financial crisis of 2008 spreads in the junk bond market peaked near 20%.
Higher corporate bond spreads are something investors need to be aware of. This explained some of the recent weakness in the stock market. However, spreads have not widened to the point, where it would imply that a recession is likely. The fact that corporate spreads are starting to narrow again is a good sign, though it is something that an astute investor should monitor going forward.