When stock markets appear directionless, it is often because of investor uncertainty, resulting in a “flight to safety,” as they say in market jargon. In this expression, “safety” has to do with investors’ perceptions of the different forms of risk. When confidence levels are high, investors move out of the bond market and invest in the stock market; when confidence is low, they do the opposite. It is interesting to analyze the relative risk of these two markets, because a fundamental investment principle is based on the difference between these two forms of investment.
When we buy a bond, we choose a series of payments guaranteed by the issuer’s credit for the term of the security. This is what is called “coupons.” At maturity, the principal is paid back. In this case, the main risk that comes to mind is that we will not be paid back by the issuer of the bond. But if everything goes as expected, a five-year 7% bond will without fail provide a return of 7% at the end of five years, as provided in the contract. Bonds are traded on their own market, just like stocks. The value of a bond is always calculated according to a mathematical formula: it is the present value of the bond that we purchase, plus the principal that will be paid back to us. What causes the present value to fluctuate is the prevailing interest rate when this value is calculated. The table below illustrates the value of an amount of $100 invested at various rates for different numbers of years.
First, if we look at the table line by line, we see that no matter what the term, be it two years, five years or 30 years, the present value of the $100 falls when interest rates rise. The value of a bond is the sum of the present value of all the payments provided in the contract. Another thing we can see is that the further out in time the future payment, the less it is worth today. Also, the loss in value due to an increase in interest rates is much larger in percentage terms when the future payment is further out in time. So it is changes in interest rates that cause the value of a bond to fluctuate, and sensitivity to these changes is a function of the time to run until the payment is received. The risk is determined by the short-term volatility of the bond price (present value). In the present case, if interest rates rise from 5% to 6%, the value of the $100 will fall by only 1.88% (from $90.70 to $89.00) in two years, whereas it will fall by 24.75% at the end of 30 years.
When we buy a stock, we are buying ownership in a company. There are no guarantees – there are no guaranteed payments and there is no guarantee we will get our money back. In many cases, the profitability of a stock investment depends exclusively on an increase in the price of the stock. There is no maturity date when our initial investment will be paid back to us. However interest rates fluctuate over time, the value of a bond usually tends towards its face value, whereas a stock can be worth just about anything. The fact that the value of a bond tends towards its face value at maturity guarantees an investor the expected return when the bond matures, but it also limits the return to the predetermined amount. Conversely, because a stock can be worth almost anything, depending on how economic conditions change over time, the risk of loss is much greater, but so is the chance of realizing big gains.
The longer the term of a bond investment, the smaller the risk advantage over a stock investment. When we speak of a “flight to safety,” we think of capital leaving the stock market and generally moving into bonds with a maturity of less than five years. Generally, 90-day U.S. government Treasury bills are the least risky investment, while shares of small-cap companies are the riskiest. All other types of investments fall between these two extremes. Investors with low risk tolerance will have a greater proportion of their portfolio in short-term bonds and the like, while those with higher risk tolerance will hold a greater proportion of stock investments.