March Market Update - Bond Yields, Stimulus Check and Inflation: Bond Market and Stock Market
Bond yields, treasury bills, interest rates – coming across these terms as a person who is just beginning to invest, they can sound confusing, repulsive, and frankly – boring. You may think to yourself, “I want to invest in stocks, not bonds. I don’t see how bond yields or interest rates could affect my investing strategy”, but the reality is that movements in the bond market are flashing a warning for the stock market.
Before we dive deep into how the bond market impacts the stock market, it is essential to distinguish one from another.
The stock market, also known as the "equity market" allows you to invest in companies that you believe will achieve success and become profitable in the near future. When you put your money into the stock market, you become a shareholder. This means you own part of a company in relation to the proportion of shares you hold. The stock market rewards you for bearing the market risk, which is essentially the volatility of the share price of the stock you're holding. This reward comes in two forms: capital gains and dividends. Many financial news and textbooks also refer to stocks as an “equity instrument”. Financial terminologies can be confusing at times, so when you think of financial instruments, remember that there are commonly two asset types: equity and debt instruments. Distinguishing an equity instrument from a debt instrument is simple – a debt instrument is a financial liability. An entity that has issued the bond has to pay back the face value of the bond to the bondholder when it expires. To simplify this, you as a bondholder will lend money to an entity (company, government) and they have an obligation to pay it back to you at a fixed date. In contrast, when trading equity instruments, no one has any obligation to pay anyone. Companies also have no obligation to pay you dividends as they can decide whether they want to reinvest the money or payout dividends to their shareholders.
The bond market, also known as the debt market is where various types of bonds are issued to individuals, corporations, and even foreign countries. Let's start with the simplest and most intuitive type of bond, government bonds. They are available to the general public. When you buy a government bond, you are lending money to the government and in return, they periodically pay you back a proportion of it based on the current interest rate. This interest rate is set by the Federal Reserve in the U.S and the Bank of England in the U.K.
Once the bond matures (in other words, expires), you can expect to receive the full amount you invested initially and the interest income incurred on top of it. This full amount you invest and get back is called the "principle". Alternatively, they are also referred to as "par value" or "face value" of the bond. The proportion of money you receive periodically before the expiration date is called “coupons''.
Now that we've covered several characteristics of a bond, we can explore corporate bonds and sovereign bonds. Corporate bonds are, as the name states, issued by corporations to raise money, and they are required to have a maturity of over a year. Corporate bonds tend to be riskier in comparison to other types of bonds as companies can go out of business. Sovereign bonds possess similar characteristics to other bonds but what makes them special is that they can be denominated in both foreign and domestic currency. It means these bonds can be traded globally and can help foreign countries to finance their economy. Fun fact! Recently President Biden imposed new sanctions on Russia after the alleged misconduct related to the SolarWind Corporation. The new sanction introduced will restrict Russia from buying new sovereign debts from the U.S market. Why is this bad news for Russia? It's because the U.S bond market is known for producing steady and strong growth in comparison to the Russian bond market.
Now as you’ve learnt about the overall financial market, you are ready to dive deeper into how markets respond to external forces. In the next part, we will uncover the impact stimulus checks have on the financial markets. It will involve industry-specific terminologies like bond yields and betas, as well as looking at stock charts to identify the beginning of a financial trend.