How bond yields move, and why stocks care

A bond is a loan with a fixed schedule. The issuer, usually a government or a company, borrows a sum and agrees to pay a set interest amount, the coupon, at regular intervals, and to repay the principal on a fixed date. Once issued, the bond trades in the secondary market, and its price moves with supply and demand.

The yield is the return an investor gets by buying at today's price and holding to maturity. Because the coupon and the principal are fixed, the yield depends entirely on the price paid. Pay less than face value and the yield is higher than the coupon; pay more and it is lower. This is why bond prices and yields move in opposite directions: a rising yield is the same thing as a falling price.

What sets the level of yields

Short-dated government bond yields are anchored by the central bank's policy rate and by expectations for where that rate is heading. A two-year bond yield is, roughly, the average policy rate the market expects over the next two years. When the central bank signals it will lower rates, two-year yields fall in anticipation.

Longer-dated yields have more moving parts. They embed expectations for the policy rate over a longer horizon, expectations for inflation over that period, and an additional amount called the term premium, which is the compensation investors demand for locking money up and bearing the uncertainty of a longer holding period. Government borrowing needs affect the term premium, since larger supply requires a higher yield to find buyers.

Inflation matters because a bond's payments are fixed in nominal terms. If inflation turns out higher than expected, the real value of those payments is lower, so investors demand a higher yield when they expect inflation to rise.

The curve

Plotting yields against maturity produces the yield curve. Normally it slopes upward: longer bonds yield more to compensate for the additional risk and uncertainty. When short yields rise above long yields, the curve is inverted, which usually happens when the central bank has raised rates sharply and the market expects it to cut later. An inverted curve has preceded most recessions in the past half-century, though the lag between inversion and downturn has varied widely.

A steepening curve, in which long yields rise relative to short ones, can signal improving growth expectations, rising inflation expectations, concern about bond supply, or some combination. Reading the curve therefore requires looking at what is driving each end.

Why equities respond

Stocks are claims on a company's future profits. To value those profits today, investors discount them using a rate that starts from the risk-free government bond yield and adds a premium for equity risk. When yields rise, the discount rate rises, and the present value of future profits falls.

The effect is largest for companies whose profits lie furthest in the future, such as fast-growing firms with little current earnings. A larger share of their value comes from distant cash flows, and those are discounted most heavily. Companies with steady near-term earnings and high dividends, such as utilities, are affected differently: they compete directly with bonds for income-seeking investors, so a higher bond yield makes their dividends relatively less attractive.

Rising yields are not always bad for stocks. If yields rise because growth is improving, the boost to expected profits can outweigh the higher discount rate. If they rise because inflation is proving persistent and the central bank is expected to stay tight, the effect is usually negative. The reason behind a move in yields matters as much as the direction.

This guide is general information, not investment advice.