What is the correlation between stock and bond returns?
Generally, when inflation is high and volatile, stocks and bonds have a positive correlation. That is, their prices move in the same direction (downward). When inflation is low and stable, stocks and bonds tend to have a negative correlation.
Amid a generalised increase in the volatility in fixed income markets and in sync with the inflation surge, the correlation between equity and bond returns has turned from negative to increasingly positive.
Inverse performance
Another important difference between stocks and bonds is that they tend to have an inverse relationship in terms of price — when stock prices rise, bond prices fall, and vice versa.
Over the past 30 years, stocks posted an average annual return of 10.4%, and bonds 6.8%. But actual returns varied widely from year to year. When people think about investing for the long run, they often look to average market returns.
Stocks have historically delivered higher returns than bonds because there is a greater risk that, if the company fails, all of the stockholders' investment will be lost (unlike bondholders who might recoup fully or partially the principal of their lending).
Higher bond yields can lead to lower share prices
Naturally, as more investors sell their stock, the further share prices could fall. Here, you can see the inverse relationship between stocks and bonds, where the value of the S&P 500 and a US Treasury bond tend to move in opposite directions.
In theory, rising stock prices draw investors away from bonds, causing bond prices to drop, as sellers lower prices to appeal to market participants. Since bond prices and bond yields move inversely, eventually, the falling bond prices would push the bond yields high enough to attract investors.
So interest rates fall, bond prices rise - vice versa. And in a recession - you know, when the stock market is usually crashing - the Fed will be anxiously cutting interest rates to boost the economy - you know? - to stem that crash. So in this situation, bond prices would tend to go up.
Even if the stock market crashes, you aren't likely to see your bond investments take large hits. However, businesses that have been hard hit by the crash may have a difficult time repaying their bonds.
U.S. Treasuries benefit from the "flight to quality" phenomenon that is apparent during a market crash, as investors flock to the relative safety of investments that are perceived to be safer. Bonds also outperform stocks in an equity bear market as central banks tend to lower interest rates to stimulate the economy.
How often do bonds outperform stocks?
Historically, bonds have generated stronger risk-adjusted returns compared to stocks in the three years following Federal Reserve tightening cycles. After the past seven tightening cycles, bonds delivered 89% of the return of stocks with only 26% of the volatility with more consistency in their range of outcomes.
General ROI: A positive ROI is generally considered good, with a normal ROI of 5-7% often seen as a reasonable expectation. However, a strong general ROI is something greater than 10%. Return on Stocks: On average, a ROI of 7% after inflation is often considered good, based on the historical returns of the market.
The rule of thumb advisors have traditionally urged investors to use, in terms of the percentage of stocks an investor should have in their portfolio; this equation suggests, for example, that a 30-year-old would hold 70% in stocks and 30% in bonds, while a 60-year-old would have 40% in stocks and 60% in bonds.
Stocks offer ownership and dividends, volatile short-term but driven by long-term earnings growth. Bonds provide stable income, crucial for wealth protection, especially as financial goals approach, balancing diversified portfolios.
Stocks offer an opportunity for higher long-term returns compared with bonds but come with greater risk. Bonds are generally more stable than stocks but have provided lower long-term returns. By owning a mix of different investments, you're diversifying your portfolio.
“Generally speaking, bonds as an asset class are less risky than stocks,” Miyakawa says. Meanwhile, stocks provide higher returns, but with higher volatility. “However, high inflation and its impact on interest rates have made answering this question [of which is better to invest in] more complex.”
If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond's price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates.
When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise. This is a fundamental principle of bond investing, which leaves investors exposed to interest rate risk—the risk that an investment's value will fluctuate due to changes in interest rates.
"Rising bond yields means that stocks have more competition," said Corey. "If an investor can earn almost 5% yield in a safe government bond, it may not make as much sense to invest in stocks, which are much more volatile and risky than bonds."
Stocks generally outperform bonds over time due to the equity risk premium that investors enjoy over bonds. This is an amount that investors of stocks demand in return for taking on the additional risk associated with stocks.
Should I move my stocks to bonds?
While it's not a satisfying answer, the real answer is that "it depends." The decision of whether to shift your 401(k) to a more conservative asset allocation will depend primarily on your longer-term goals, personal drivers of your risk/return profile and the asset allocation in your other accounts, if applicable.
If sold prior to maturity, market price may be higher or lower than what you paid for the bond, leading to a capital gain or loss. If bought and held to maturity investor is not affected by market risk.
Investment-grade corporate bonds and government bonds such as US Treasurys have historically delivered higher returns during recessions than high-yield corporate bonds.
The only other times that both stocks and bonds have declined simultaneously were in April and September of 2022—the beginning and the bottom of last year's bear market; January of 2009 in the ashes of the Great Financial Crisis; and October of 1979 following nearly a decade of ultra-high interest rates.
Alternatively, if prevailing interest rates are increasing, older bonds become less valuable because their coupon payments are now lower than those of new bonds being offered in the market. The price of these older bonds drops and they are described as trading at a discount.
