I get the general sense that bonds are preferred during declining economic conditions and/or recessions when inflation is low and interest rates are down (therefore prices up, which increase total bond return) - and that equities are generally preferred during expanding economic times.
None of this I disagree with but why aren’t bonds considererd at all during strong economic times? Bond yields are typically high and can be bought at discounts which factors into total return – is that still deemed inferior to equities. I guess the only real reason I can think of is that inflation kicks up during economic expansion which is like death to fixed income securities.
Can anyone expand on this (or tell me if I’m wrong) and why equities seem to be the unquestionably better investment in good economic conditions?
in good economic conditions the demand for bonds is less as investors turn to inflation hedging assets and assets that correlate well with economic growth, so prices are not bid up by great demand (as they are in ‘bad’ times) and consequnetly the yields are not as low as they would be during a recession when the ‘safety’ aspect of government and investment grade bonds is highly valued. but you should think about this as an equilibrium state, rather than start from the observation that yields are higher and then ask why don’t investors cram into the market. Moreover I dont think anyone is saying that investors shy away from bonds alltogether when economic conditions are good, it’s just a matter of how the investor will decide to modify their basic allocation to take advantage of the business cycle.
I guess I was trying to establish in my mind some form of relationship between asset classes and economic conditions, which I do think exists for the reasons we’ve stated. But I was probably trying to paint with to wide a brush as it’s not always so cut and dry. It obviously depends on the investor, their needs and the allocation that accomodates those needs, which might include bonds in strong economic times.
I guess I was just getting the sense from practice problems that bonds are an inferior investment during strong economic times, and I just couldn’t totally understand that. They can be bought at a discount with strong yields - not an entirely terrible outcome. That said, I understand the inflation risk and that they are generally less correlated with the market and might not provide the kind of total return that equities can during good times.
Who said people don’t by bonds when the economy is good?
Can someone help me better understand the following statement. Not sure I am conceptualzing the “demand for loanable funds…” part correctly. I loosely tend to think that during a recession, people flock to bonds which drives up bond prices and decreases yields.
“If short-term interest rates increase enough such that a recession becomes more likely, the yields on bonds will fall as investors anticipate that the demand for loanable funds will fall”
if short-term interest rates increase a lot than it will be too dear to borrow money. credit is a very important function of the economy and when the economy is stifled of this precious resource it may well go into recession or worse. in anticipation of such an event, inestors investors will bid up the price of bonds so their yields will fall.
Not sure I follow your last sentence.
So in anticipation of future lending/borrowing shortages due to higher rates, investors will take advantage now by buying up bonds which increases prices but lowers yields? Like a pension company buying the bonds they need now to match asset maturities. They do so while the bonds are available and therefore drive yields down??
while the economy is growing, confidence is high and lots of people want to borrow money. Consumers want to buy bigger houses, businesses want to build new factories etc etc. So the demand for “loanable funds” goes up, and lenders can demand higher rates in return for their capital. (ie, higher yields). Yields also go up because inflation is likely to be accelerating. This process happens until a point where loans just become too expensive, and demand for them dries up. (Imagine how much demand would drop for mortgages if you had to pay 20% interest a year, for example.) This can cause a recession because it means people/businesses are spending less, so growth will slow. If less people want to borrow money and the economy is slowing, bond yields will start to fall. So investors try to work out where the ‘peak’ is for interest rates, and buy bonds at the right time to profit from the rally. back to your original question, i don’t think anyone’s suggesting you should hold 100% equities in a strong economy and 100% bonds in a weak one. Bonds are still important to diversify your portfolio regardless of the economy. But if you were to directly compare the two asset classes at a point in time where the economy is doing well, equities are better.
Thanks, K. Very helpful!
I want to make sure i’m on the same page since the text (particularly in regards to the busienss cycle) tends to differentiate between “rates” and “yields”. They are often used interchangeably and clearly the ladder tends to build off the former, but how would you distinguish between the two, if you had to. Just want to hear someone else’s thoughts.
I tend to think of rates as coming from the rate setting authorities (eg Fed) and comprising the real underlying return. Whereas yields tend to relate more to the liquid bond markets and daily YTMs. But i tend to think the two track in much of the same fashion.
think the build-up or risk premium approach.
yield = RIDIMT (all additive).
- Risk Free