Will a Falling Dow Keep Making Bonds Soar?

The Dow Jones Industrials scored another triple-digit decline Wednesday, but bond prices soared as yields plunged to their lowest levels in almost a year.

May 15, 2014 at 5:15PM

The Dow Jones Industrials (DJINDICES:^DJI) fell sharply on Thursday, as nervousness about the length of the bull market and concerns about economic data today helped send stocks to a second-straight day of triple-digit losses. By the close, the Dow had dropped 166 points, but the bond market painted a very different picture, as prices climbed and the 10-Year Treasury Yield (TREASURY: TC10Y) fell to its lowest levels in almost a year. Let's take a closer look at what's behind the drop in bond yields, and what it means for Dow components Verizon (NYSE:VZ), Boeing (NYSE:BA), and other stocks.

Bond
Source: U.S. Treasury.

Why bonds have performed so well
Coming into 2014, nearly everyone expected that bond yields would climb precipitously, sending bond prices plunging. The Federal Reserve had already indicated at the end of 2013 that it would start tapering its purchases of bonds under its quantitative easing program, and therefore, market participants expected that the reduction in bond demand would lead rates to rise naturally. After all, even the threat of a Fed taper was enough to send yields soaring in mid-2013.

This time around, though, the bond market had the opposite reaction. Stocks struggled and, despite the constant reduction in Fed bond buying, yields remained stubbornly low. Today, the 10-year yield fell below 2.5%, about half a percentage point below its most-recent highs, and enough to potentially spur some minor refinancing activity for mortgages and other borrowing.

One source of support for bonds has been that the strong performance in the Dow Jones Industrials last year and in the U.S. economy has made Treasuries more attractive to foreign investors, especially as other countries look to bolster their stimulus incentives, and move toward easier monetary policy. Believe it or not, yields of 2.5% to 3% look fairly attractive compared to rates in Europe and Japan right now.

Bonds

Source: U.S. Treasury.

But another reason bonds have done so well is simply that investors in the Dow Jones Industrials are no longer convinced that the stock market has the growth potential to justify the risks involved. Even some stalwart defensive stocks are trading at 20 times earnings, which is a rich valuation in just about any market. The way that momentum stocks have fallen much more sharply than the overall market indicates the lack of risk tolerance among investors, who want to avoid any chance of a repeat of the 2008 market meltdown.

How low bond yields help Verizon more than Boeing
As a result of the push lower in bond yields, some companies in the Dow Jones Industrials have fared better than others. Verizon, for instance, has been the biggest beneficiary of low interest rates, as they made its acquisition of its Verizon Wireless subsidiary possible. With a strategically crafted offering of debt securities, Verizon was able to avoid overloading the market by having to issue too many new shares. As long as bond yields remain low, then Verizon will be able to refinance those bonds, and take its time in paying them down.

By contrast, some companies already made the decision to cut back on their debt and, therefore, haven't taken full advantage of low rates. Boeing has lowered its debt-to-capitalization ratio by about 25 percentage points during the past year. At the time, that seemed like a prudent way to avoid refinancing risk at what were projected to be higher rates this year. Yet, with bonds falling, Boeing's timing has turned out not to be ideal.

As long as investors fear the stock market, bonds will have the capacity to do well, even at today's low rates. At some point, though, the Fed will start pulling out the rug from under the bond market, and that could cause long-term problems for Verizon, Boeing, and other corporate borrowers.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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