Sunday, 16 August 2015

What Can We Learn About Stocks From Bonds

Most people are not familiar with bonds. They prefer the excitement of stocks which brings instant judgement over their buy or sell calls rather than wait patiently for years to collect coupon payments. However, there are something that bonds can teach us about stocks. With the recent volatility in the stock market, it is perhaps useful to know what can we learn about stocks from bonds.

The price volatility of a bond comes mostly from interest rate changes. However, not all bonds exhibit the same sensitivity to interest rates. There are several factors that affect the interest rate sensitivity of a bond. These are: bond maturity (i.e. how many more years before the bond expires), coupon rate (i.e. how much "dividends" the bond will pay semi-annually) and credit risk (i.e. how likely is the bond issuer able to honour its coupon and principal payments). The longer a bond's maturity, the more volatile is its price to interest rate changes. As stocks are perpetual securities with no maturity, they are thus more volatile than many other investment assets. Based on the Dividend Discount Model, any slight change in the discount rate can lead to a huge change in the intrinsic value of a stock because of the perpetual maturity.

As for coupon payment, the higher the coupon rate, the less volatile is a bond's price to interest rate changes. Thus, we can expect stocks with higher dividends to be less volatile compared to stocks with lower dividends. This is the case in practice, since investors are more willing to stay invested in a stock if it is able to pay high dividends while the stock market undergoes a downturn.

Having said that, not all dividend stocks will be equally resilient to market downturns. Much will depend on the stock's ability to keep its high dividend rate throughout the downturn. This is similar to a bond's credit risk. In an economic downturn, the ability of the bond issuer to earn sufficient money to cover its coupon and principal payments is in greater doubt and hence, the bond's price will fall much more than that indicated by interest rate changes to reflect the greater uncertainty in coupon/ principal payments. In fact, if a company does not earn enough money to cover its coupon payments, its stock dividend will also be cut. This is why junk bonds with high yields can be as volatile as stocks in an economic downturn. Hence, among dividend stocks, it is important to identify which of these are vulnerable to dividend cuts and avoid them.

Many investors like REITs for their high dividends. However, not all REITs will be able to sustain their dividends and provide a comparatively safe harbour to sit out the market correction. As an example, I had written about the vulnerability of hotel trusts to currency fluctuations in Getting Ready for US Interest Rate Rises in Jun. Since then, currency fluctuations have increased with the recent devaluation of the Chinese Renminbi and all 3 hotel trusts mentioned had fallen by an average of 12% over a short period of 2 months. 

In conclusion, bonds have certain similarities to stocks and understanding bonds can help us to understand stocks as well.

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