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Bonds: When the Tail Wags the Dog

Nathan BearNathan Bear ·

Find your edge and then exploit it. 

With the Dow posting above 28,000 for the first time ever, traders are wondering how much more room does this market have to run. 

Let’s forget for a moment that the President is going through an impeachment inquiry and that we still don’t have a definitive trade deal with China—the market is certainly ignoring it.

So if it’s not the news that’s driving this market, then what is?

If you want to know where the stock market goes next…

Then there is one place you must look at first.     

I’m talking about the good old bond market.

Most traders don’t realize how important the bond market is. Every stock investor, whether they know it or not, uses the bond market to price their stocks.

In fact, the bond market has predictive powers, and I’m going to teach you how to exploit it and strategies to profit off it.


Bonds vs. Stocks


What’s the least risky investment you can make? Most people think of a certificate of deposit or a savings account at a bank. You earn interest, and your principal is guaranteed.

Investors can’t really use these in mass quantities. So they turn to the bond market. They consider U.S. Treasury debt to be the safest investment available. This is often referred to as the ‘risk-free rate.’

Is it truly risk-free? Not really. But then again, if the U.S. government defaults on debt or collapses, how much money you make on a treasury note will be the last thing on your mind!



So let’s use this as our baseline for the lowest possible risk. 

Investors consider debt safer than equity in most cases. Debtors are required to make payments according to the debt contract (basically a loan). However, you don’t get to share in the company’s profits.

Stockholders share in the profits but aren’t guaranteed any payments or returns. So they take on more risk to get a greater potential return. This return comes from three possible sources:

  • Share price increases
  • Share repurchases (which has the effect of increasing share price)
  • Dividends

At their core, investors seek safety in bonds and higher returns from stocks.


Bond basics


Let’s quickly discuss how bonds work.

Investors loan money to companies. The contract they create is known as a bond.

Bonds pay a set amount known as the coupon (or provide compensation to investors through some other mechanism). It’s like the interest payments on a loan. The interest rate paid by a bond is known as the yield.

If you receive a $50 payment on a $1,000 bond, you get a yield of $50 / $1,000 = 5%.

The amount paid never changes. But, the price of the bond could. If I paid you $2,000 for that same bond, I’d be getting a yield of $50 / $2,000 = 2.5%.

Conversely, if I only paid $500 I’d get a yield of $50 / $500 = 10%.

Important note: The price of bonds and the yield have an inverse relationship. This means if the price of bonds rises, the yield decreases. When bond prices drop, yields increase.


How bond prices influence stocks


Let’s consider the 10-year treasury notes. Investors like this because it matches with most people’s investment horizon.

The yield on the 10-year note ranged from 1.336% to almost 4% in the last decade.


10-year treasury yield


Imagine you had $100 to invest. You look around, and you see that the government bond yields 3% and a dividend stock like AT&T yields 3%. Which would you choose?

All things being equal, you want the bond because it’s a safer bet. 

That causes fewer people to want AT&T. But AT&T still pays the same dividend amount.

So the price of AT&T drops. All of a sudden, that 3% on AT&T starts creeping up to 4%, then 5%, until at some point you decide that the risk to reward on both is equal.

This is exactly what happens with dividend-paying stocks like utilities and large caps. When bond prices decline, the yield climbs (because they still pay that same $50 no matter the price).

Now that you get a better deal on bonds, you want something better from a dividend stock. So when bond prices increase, investors tend to buy dividend stocks.

Conversely, when bond prices decline, so do the prices of dividend stocks. Check out this chart that graphs the utility sector (XLU) against the 10-year treasury yield. Notice how, as the yield on treasuries declines (meaning bond prices increase), the price of utility stocks increases.



How to incorporate this into your trading


The relationship between bonds and stocks works out over time. But, intraday, you can find divergences. That creates opportunities for us as traders.

Knowing where to look for these is half the battle. I’ve learned how to incorporate this information into my daily routine to take my trading to the next level.

If you want to learn how to take your trading up a notch then join me at Weekly Money Multiplier. I will make you a better trader.

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