Over the past year, the UK 10-year government bond yield has jumped from 3.18% to 4.35%. For the yield to rise, it means that the price of the bond has fallen sharply. It’s not just in the government bond markets where this has happened. Corporate yields have also risen. Even though I’m primarily a stock investor, I’ve noticed several key impacts from the bond market worth flagging up.
Interest rate expectations
One key concern on the minds of investors is when interest rates will peak and potentially even be cut. This is important because it should help to spark a stock market rally. When the base rate increases, it puts more pressure on companies as it makes debt more expensive. Further, it decreases demand from customers as they feel the pinch from a higher cost of living.
The reverse is also true. When the rate falls, easing conditions historically have been very positive for business.
The bond market helps because the yield is used as an estimate of where investors think the interest rate will be at the time of the bond’s maturity. For example, the two-year government bond has a yield of 4.60%. This gives me optimism for the stock market, as investors appear to be factoring in rate cuts within the next two years from the current base rate of 5.25%.
Being selective on dividend shares
Another way bond markets are impacting the FTSE 100 relates to income investors. At the start of the pandemic when bond yields were incredibly low, buying a stock with even a mere 2% or 3% dividend yield made sense.
Yet with bond yields now much higher, income investors are having to sift through options a lot more carefully to find the right gems. I don’t see this as a bad thing — in fact it’s a positive. It means that bad companies with unsustainable yields are being ignored in favour of firms with genuine potential for high yields.
For example, it has shone a lot more of the spotlight on a stock like Aviva. The 7.82% current yield is generous, but I think it is sustainable, based on the fundamental outlook for the company.
The opportunity cost
Historically, some investors would shy away from the stock market and go for the perceived safer option of the bond market. Yet the rising yields (and falling prices) means that most bond market funds are due to lose money for the third straight year.
This means that the opportunity cost of putting money in the bond market is much higher than some thought it was. For example, if I’d invested in the FTSE 100 instead of the bond market exactly three years ago, I’d be up 33%.
I think that the poor returns on the bond market is pushing more to invest in the stock market instead. I believe this is already happening right now, but should pick up more in 2024. As a result, this could help to spark a rally in the FTSE 100.