What Happens to Stocks When Bonds Decline – Backtesting Insights

The relationship between stocks and interest rates is at the center of financial theory. Why? Because the interest rates determine the value of stocks. High rates equal less appetite for owning risky assets, and investors will only own risky assets if they are compensated for taking this risk. What happens to stocks when bonds go down (what happens to stocks when interest rates go up)?

When bonds go down and interest rates go up stocks perform poorly. A lower price for the bond means that the yield and interest rates go up, and future cash flows get discounted at a higher rate. When rates go up, it’s less attractive to own risky assets like stocks as it’s more attractive to own less risky assets. We backtest our hypothesis.

The relationship between bonds and stocks

It’s crucial to understand the relationship between bonds and stocks. They both correlate to each other. When bonds go up in price, stocks also tend to go up. Higher bond prices mean the yield goes down, which is positive for stocks.

Opposite, when bond prices go down, meaning rates go up, it is bad for stocks.

Let’s give you a short primer on bonds:

A bond pays the same coupon during its life – until the bond matures. The coupon is being paid annually to the bond owners (for taking the risk of owning it).

For example, a bond with a coupon of 5% pays 5% until the bond matures. Let’s say 20 years. A one billion bond that has a coupon of 5% pays 50 million annually to the bond owners.

But during the bond’s life, the interest rates vary a lot. If the rates go down, the 5% loan is more attractive and thus investors bid the price of the bond up. Why? Because the price of the bond needs to go up to reflect the falling rates. The price of the one billion bond needs to go up 10% to reflect the change of the rates to 4.5% (this is just an example, in the real world a bond is influenced by a lot of factors). This means that stocks and rates have an inverse relationship.

What happens to stocks when interest rates go up? A video

Stocks are riskier than bonds

When a company goes bankrupt, what is left in the company is paid to the bond owners before anything is paid to equity holders.