Rising Bond Rates Impact on the Stock Market
By JG Chambers
The recent stock market sell-off prompted a herd mentality among many investors. Moving with the flow of the crowd, investors large and small sold enough shares to cause the Nasdaq to fall 4.1%, S&P 500 3.3%, and Dow close to 5%.
Bond yields had much to do with the sudden drop in the stock indexes and there are reasons bond rates can prompt a down turn in the equities markets.
The Federal Reserve began to move short-term interest rates higher over a year ago and signaled it would raise rates further to 2.5 percent in December 2018, 3.0 percent in 2019, and 3.5 percent in 2020. Short term prime rates are a primary reason for bond rates going up.
The Fed game plan to increase prime rates over time signaled the bond market to strengthen its yields. On October 9, the 10-year note yielded 3.25%, following indications from the Federal Reserve that more rate hikes are in the future.
Individual and institutional investors view rising interest rates as a signal to move dollars out of the equity market and into fixed income investments. Rising bond yields throw off more interest income and are safer alternatives compared to dividend income from stocks.
Bonds compete for investor dollars and investors will seek the highest investment income with the greatest margin of safety.
Both the Fed prime rate and resulting bond yield are also a reason for determining the U.S. economic outlook. Economic expansion or contraction will respond to the costs of borrowing money.
Higher bond yields force companies to spend more dollars for expansion projects, resulting in more debt on their balance sheets. Thus, companies often cut back in research, development, and capital expansion when borrowing costs increase.
Investors also become sensitive to business slow downs and follow these closely. Because investors view their stock ownership as part ownership in a company, any expectation of business contraction affects their decisions to hold stock.
Negative changes in company growth and expansion result in lower cash flow, less money to pay stock dividends, and less incentive for owning a company's stock. Thus, stock valuations drop along with share prices.
When the Federal Reserve consistently raises prime interest rates and bond yields follow, history reflects money flowing out of stock investments and into bonds. As rates have steadily risen this year, this pattern has followed. Money has clearly moved from stock funds into bond investments with stock share prices dropping in lock step.
For the personal investor with a long holding period, rising bond yields are not a cause for alarm. The investor with a portfolio of growth stocks will see falling stock valuations as corporate businesses contract. For the investor primarily holding dividend stocks, not only will share prices contract but continued dividend increases become a concern.
However, personal investors holding shares in good companies with track records of solid performance can weather adverse effects on the economy as it relates to rising bond yields. The message here is that the caliber of a company and strength of its management team is much more important in the long run than any impact bond yields may have on the economy.
I have been an active investor for over 35 years. With the exception of employer 403(b) retirement plans, my investments have always been self-directed. My preferred investment style would fall into value investing with dividend growth and income as a long term objective.
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