Will Share Prices Fall With Bonds?

The story in the financial world is bonds. A couple of weeks ago traders worldwide suddenly decided that interest on the dollar won't be receding any more, and indeed might rally. They then started dumping bonds almost indiscriminately, around the world - and here too.

In the U.S., 10-year treasuries, a benchmark to bond markets the world wide, plunged to a five-year low reflecting a yield to maturity of 5.3%. Here too, fixed-income bonds took a body blow. Within three weeks they'd fallen 5%, though in recent days prices bonds clawed back a little.

People who invested in bond funds in May learned to their sorrow that the "conservative" fund they'd chosen could be pretty wild, and could lose real money.

The equation is clear: if interest rates climb in the United States and the rest of the world, then bond prices will fall, for the time being. How will all this affect share prices? When bonds fall, will shares suffer?

Interest rates rose but only stocks took off

Based on simple economic logic, that should be a yes. Since the price of a share should be a function of the cash flow that the company is expected to produce in the years to come, but is "capitalized" based on the interest rate - then an increase in the interest rate should immediately diminish the value of the share.

Also, revenues at many companies, such as the banks, brokerages, investment companies and insurance companies, are affected by trends in the bond market. If interest rates around the world rise, their profits will fall.

We can also address the issue in terms of alternative investments. Would investors continue to horde to the stock market if risk-free government bonds were offering 7% interest? That is not an idle question: yields on fixed-income Shahars were 5.5% last week.

But theory is one thing and reality another. The history of the financial markets teaches that often, the logical link simply does not apply. The Herald Tribune found that in the last 15 years, there were four crashes (defined as 10% or more) in the U.S. bond market. What happened to share prices? In three cases, they rose, by a steep 20% or more.

In other words, if you cleverly predicted interest rate hikes ahead of the event and fled U.S. stocks, you'd have missed major rallies in share prices.

Backwards logic

How could economic logic work backwards? The main reason is that when bond yields are rising, which happens when bond prices are falling, happens precisely during economic booms. The yields rise because central banks are trying to prevent economic over-heating and spiraling inflation.

At such times, corporate profits rise sharply. The improvement in their situation can compensate and more from the damage of a bear bond market. During times of rising inflation, the price of unlinked bonds will fall, because they are unprotected against the eroding value of money. Shares on the other hand give the holder a portion of the company's profit. Companies that actually do something are a real asset and their managers simply raise product prices. Therefore, corporate shares are felt to provide pretty good shelter during inflationary times.

Bonds have room to fall

And what will happen this time around? First of all, barring drama on the military front, what will set the local trend is foreign exchanges and markets. If U.S. T-bills continue to falter, then fixed-income Israeli bonds will drop too. If Nasdaq and the other world stock markets start to fall, then Tel Aviv stocks will hurt too.

But that still doesn't answer the big question: if U.S. bonds continue to fall in price, will U.S. stocks drop too?

According to the Tribune, that depends. As of today, even after the slide in the last two weeks, bond prices are still low compared with their multi-annual averages.

Here are the figures. In the last 20 years, the average yield on a 10-year T-bill was 6.2%. Yesterday the yield was 5.2%.

That indicates that the yield has room to rise, which means that bond prices have room to fall, without significantly hurting corporate profits and share prices.

By that scenario, bonds could fall while stocks rise, abroad and here too.

However, if the rise in bond yields becomes steeper, your money will have no safe harbor other than short-term deposits and cash in the bank.