Stocks and bonds are distinctly different investment instruments, but there are a few correlations between the two that can cause ripple effects between bonds and the stock market. Stocks and bonds can be issued by the same companies, making the values of both inextricably tied to the performance of a single entity. Because of this, despite how it may seem at first glance, there is a solid relationship between bonds and the stock market.
Companies issue stock to raise a large pool of debt-free capital in a short period. After buying stock, investors can trade their shares on an open exchange, where prices are set by the market to reap a profit on their investment. Stocks, unlike bonds, do not mature or expire. Companies must actually repurchase shares of stock to go from public back to private.
Bonds are a form of debt offered by companies to individual and institutional investors. Unlike stock, money brought in from the sale of bonds must be paid back with interest over a specified period of time. Bonds have less strings attached than stocks, however, since the company's relationship ties with bondholders are completely severed at the end of the repayment period.
Issuing bonds can help a company to finance expansion plans which, if successful, can result in higher sales and market share. Because of this, stockholders may take cues from the issuance of bonds and expect the value of the company's stock to increase. If enough buyers believe the stock price will increase, their buying activity can actually cause it to do so.
If a company defaults on a bond issuance — meaning they cannot make the interest or principal payments they promised — stockholders may see it as a red flag. Companies in financial trouble can experience rapid stock price declines as stockholders let go of their shares and watch from the sidelines. Because of this, defaulting on bond payments can start a chain reaction that ends with diminished stock valuations.
Companies with established reputations in the stock market may find it easier to sell bonds at a lower interest rate than newer companies. Conversely, if a company has a reputation of struggling on the stock market, it may find itself paying premium rates on its bond issuances. This correlation can have ripple effects in bond trading markets, causing the smaller companies' higher-interest bonds to sell at a premium.
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