When interest rates fall, existing bonds pay higher interest than new bonds coming on the market. The higher-interest bonds go up in value because investors will pay more to get their better rate. Falling interest rates promote rising stock prices as well, because companies keep more profits when they borrow at lower interest rates. Conversely, stock prices drop when interest rates rise. When stocks and bonds lose this correlation, something besides interest rates is at work.
The best correlation between bond and stock prices occurs with safer, stable stocks that pay dividends, according to a 2010 study, "Co-Movement and Predictability Relationships Between Bonds and the Cross-Section of Stocks." The prices of these kinds of stocks tend to move in the same direction as bonds.
Volatile stocks, or stocks of young companies, tend to be much more unpredictable than bonds. In fact, the prices of these stocks can be so erratic that no correlation exists between them and bonds. Interest rates are not the determining factor in these stock prices because investors consider other factors, such as profitability, potential for growth, cash flow and acceptance of the company's products and services in the marketplace.
The stocks of companies that have profit losses, negative cash flow and falling sales tend to behave without any correlation to the bond market. The larger concerns of interest rates and the effect of inflation on equities do not come into play as much with distressed companies. Investors value the stocks of these companies based on the circumstances of each business.
Flight to Safety
A negative correlation can exist between bond prices and stock prices during a "flight to safety." This happens when stock prices drop dramatically, or when investors fear that they are about to. Investors might then pull their money out of the stock market and place it in bonds, which generally are considered safer. Under these conditions, bond prices will tend to rise because of increased investor buying, and stock prices will decline.
Even when bonds and stocks have a correlation in their price movements, they don't necessarily move at the same time. For example, bonds might drop in price a few weeks before stocks do. This can be due to rising interest rates. The higher rates immediately make existing bonds worth less, because they pay lower rates than new bonds. However, the effect of higher interest rates on corporations might not be clear until companies issue their financial reports weeks or months after the bond drop. If those reports show that higher costs for borrowing money have eaten into profits, company stocks can drop in price just like bonds did.
Video of the Day
- CBS MoneyWatch: The Correlation of Bond and Stock Returns
- Seeking Alpha: Contemplating Asset-Class Correlations: Stocks, Bonds, Commodities, REITs
- The Wall Street Journal: Correlation of Stocks and Bonds Becoming Less Extreme -- Adviser
- Harvard Business School: Comovement and Predictability Relationships Between Bonds and the Cross-Section of Stocks
- Thinkstock/Comstock/Getty Images