What Happens To Stocks When Bonds Go Down? (Trading Strategy Backtest)

Last Updated on September 19, 2022 by Quantified Trading

The relationship between stocks and interest rates is at the center of financial theory. Why? Because the interest rates determine the value of stocks. High rates equal less appetite for owning risky assets, and investors will only own risky assets if they are compensated for taking this risk.

What happens to stocks when bonds go down? When bonds go down stocks perform poorly. A lower price for the bond means that the yield and rates go up. When rates go up, it’s less attractive to own risky assets like stocks as it’s more attractive to own less risky assets. We backtest our hypothesis.

The relationship between bonds and stocks

It’s crucial to understand the relationship between bonds and stocks. They both correlate to each other. When bonds go up in price, stocks also tend to go up. Higher bond prices mean that the yield goes down, and this is positive for stocks.

Opposite, when bond prices go down, meaning rates go up, it is bad for stocks.

Let’s give you a short primer on bonds:

A bond pays the same coupon during its life – until the bond matures. The coupon is what is being paid annually to the owners of the bond (for taking the risk of owning it).

For example, a bond with a coupon of 5% pays 5% until the bond matures. Let’s say 20 years. A one billion bond that has a coupon of 5% pays 50 million annually to the bond owners.

But during the life of the bond, the interest rates vary a lot. If the rates go down, the 5% loan is more attractive and thus investors bid the price of the bond up. Why? Because the price of the bond needs to go up to reflect the falling rates. The price of the one billion bond needs to go up 10% to reflect the change of the rates to 4.5% (this is just an example, in the real world a bond is influenced by a lot of factors). This means that stocks and rates have an inverse relationship.

Stocks are more risky than bonds

When a company goes bankrupt, what is left in the company are paid to the bond owners before anything is paid to equity holders. Thus, bonds are less risky than stocks.

When rates go up (bonds go down) it gets less attractive to own stocks. Stocks get bid down. When rates go down, it’s more attractive to own riskier assets like stocks, gold, and
Bitcoin.

The bond and stock relationship is, of course, not constant. That is why both of them move up and down on a daily basis to adjust for new future expectations. However, we believe it’s safe to anticipate that the correlation is higher between bonds and stocks when inflation goes up. Since the early 1980s, we have witnessed a 40-year bullish run with falling rates , in some countries even negative nominal rates, not to mention huge negative real rates.

What happens to stocks when bonds go down?

Our hypothesis is that a falling bond market is not good for stocks. Let’s backtest what happens to stocks when bonds go down:

We are long stocks (SPY) when bonds (TLT) are below the N-day moving average, and we sell when it’s above the N-day moving average.

For example, when TLT crosses below its 20-day moving average, we buy SPY at the close. When the close of TLT crosses above its 20-day moving average, we sell SPY at the close and are out of the market until TLT later crosses below its 20-day moving average.

What are SPY and TLT? SPY is the ETF that tracks the S&P 500 and TLT is the ETF that tracks US 20-year Treasury bonds. When TLT goes up in price, the interest rates go down and vice versa.

We backtest by doing an optimization where we test a wide range of moving averages from 5 days up to 100 with 5-day intervals (in total 20 backtests). The results look like this:

The first column shows the number of days in the moving average and the following columns show the trading results of each number of days in the moving average. The important column is number 3 which shows the average gain per trade. The averages in column 3 are lower for all rows compared to any random day.

Let’s look at a specific backtest: we chose the 15-day moving average. This is how the equity curve looks like from 2003:

There are 355 trades, the average gain per trade is 0.16%, CAGR is 2.37%, and max drawdown is 50%.

Opposite, if we flip the buy and sell signals, we get much better results:

What happens to stocks when bonds go up?

What happens to stocks when bonds go down? Conclusions

Our backtest shows what happens to stocks when bonds go down: that stocks perform much worse than any average random period. This is according to financial theory, and proves that it’s less desirable to own risky assets like stocks when bonds go down.

 

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