Talk to virtually any financial adviser worth his or her salt, and one of the first lessons you’ll learn about investing is diversification. This applies at a number of levels, but at its most basic, it’s among asset classes, meaning you should have a portfolio not only containing stocks, but also some bonds as they complement one another in risk over time.
Some investors, however, choose to allocate little to none of their portfolios to fixed income, either because they simply dislike the products prospects or because they consider bonds to be out of their water. Either way, even the most stock-centric of investors still should at least pay attention to the bond market, as bond prices and movements can have a profound effect on your portfolio.
Click to Enlarge Start out with the yield curve, which is simply a graphing of the yields in various-maturity government bonds — these go from very-short-term (3-month) Treasuries to longer-term (30-year) notes. For instance, this “traditional” yield curve on the right (graphic courtesy of FX Words) shows yields rising across the maturity timeline.
Well, in addition to describing Treasuries’ income situation at any given time, the yield curve provides investors with a “guide” on future expectations of inflation and economic activity.
In the case of a normal curve, investors would expect a growing economy, reflecting a belief that there will not be any significant bouts of inflation or credit disruptions, and risking money for a longer period of time will provide a premium reward in both long-term interest rates and capital appreciation.
Thus, stock investors might expect steady growth and profitability out of Wall Street companies, too. In this environment, you could take a little bit more risk here looking for outsized growth potential. For instance, 3-D printer maker 3D Systems (NYSE:DDD) or online travel site Priceline (NASDAQ:PCLN) would become more attractive.
However, an inverted yield curve — which suggests higher returns for shorter bond maturities — can hint at an economic slump. It’s not a perfect correlation, but inverted yield curves often are a predictor for recession and a difficult market. Thus, defensive, income-producing plays would be advisable; names like McDonald’s (NYSE:MCD), Procter & Gamble (NYSE:PG) and Johnson & Johnson (NYSE:JNJ), while not quite recession-proof, provide a level of safety for investors.
Still, you will want to be careful with your investments, as the steeply inverted yield curve in 1981 preceded a recession in 1982-83, with stocks following the economy down. This can lead to the worst-case scenario: the “flight to quality.”
A flight to quality is when investors think an asset class — say, stocks or commodities — is grossly overvalued and either due for a big fall or are already falling, so they sell off in droves.
Sometimes this means a flight from growth stocks to more defensive stocks, but in the worst of times, it can be a shift from even the most steady equities to U.S. government debt, generally regarded as the safest assets on the planet. The ensuing fallout is a sometimes precipitous drop in the abandoned assets, as occurred with equities in 2009 when investors everywhere dumped stocks, loading up instead on U.S. Treasury notes, bills and bonds.
Obviously, most people can’t exactly predict a flight to quality, even by looking at bond yields. You might not be able to predict a flight to quality, but certainly having an eye and an ear open to the signs makes perfect sense — even if you don’t have bonds, or a bond portfolio at risk.
Stock investors also want to keep in eye on bond markets as a measure of return. Bond yields might not be a perfect measure of comparative yield since their risk profiles are different, but many stock investors still use them as a proxy against which a stock’s dividend yield is measured.
Today’s 10-year Treasury yields under 2%; thus, investors should ask themselves whether any company yielding 2% or less in dividends is worth the added risk of being in equities. (Ergo, are there growth opportunities, too?) And naturally, that makes dividend-paying stocks yielding significantly higher than T-notes more attractive to many investors, especially if their businesses are considered reliable.
Stock investors looking to crush bond yields can turn to a number of companies. AT&T (NYSE:T), for instance, not only yields more than double the 10-year T-note at 4.75%, but its business is a virtual duopoly — one shared with another high-yielder, Verizon (NYSE:VZ). Chip maker Intel (NASDAQ:INTC) yields north of 4%, and Microsoft (NASDAQ:MSFT) yields in excess of 3% — while neither have spectacular growth prospects, you can make the case that both should remain level for years down the road.
The lesson? Stock investors shouldn’t just turn a blind eye to the bond market. It’s a predictive tool and a measuring stick for return, so pay attention … even if you have no intention of investing.
Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing, he was long MSFT, JNJ and VZ.