Relationship Between Stocks and Bonds
You should be aware of the relationship between stocks and bonds. Just to refresh your memory, a stock represents a piece of a company owned by an investor, and a bond represents a loan to a company or to a government agency for which the lender receives interest payments.
Bonds are Generally Safer
In general, a company’s bond is safer than its stock. By “safer” we mean that you are less likely to lose your money with bonds than with stocks when looking at investing in one company. As we discussed earlier, a riskier investment has the potential to pay you more than a safer investment. This is why the interest rates on some bonds are usually low compared with the amount of money you can make when the value of stocks goes up. Of course, there is no guarantee that the value of the stock will go up at all. But this is part of the risk you take when you invest.
Moving Between Bonds and Stocks
Many investors own both stocks and bonds. Sometimes they will switch their money from stocks to bonds, and other times they will do the reverse. Exactly when they make the switch partially depends on inflation. This is because the interest rates paid on bonds depend on inflation – the higher the inflation rate, the more interest borrowers will have to pay lenders to make up for the fact that inflation will eat up the payments they are making to these lenders.
Therefore, the higher the interest rates, the more attractive bonds are to most investors looking for a safer place to put their money. This movement of money from stocks to bonds is known as flight to quality, because investors seek safer, higher quality investments for their money.
Watching The Bond Market
One way investors keep track of what is happening in the bond market is to keep a watchful eye on the U.S. government bond called the 30-year Treasury Bond, also known as the long bond. The interest rate or yield (as it is called) of this bond is published every day in financial news sources. When the yield goes up, investors know that inflation may be on its way. The long bond is the basis for the interest rate home buyers have to pay on long-term mortgages, so it is very important for the ordinary consumer.