How Do Low Rates Affect the Demand for Bonds?

Low-interest rates found on bonds, especially government-backed bonds, are often seen as unappealing by investors seeking strong returns or yields. The returns associated with low-interest rate bonds, relative to stocks and other securities, are a driving force behind certain investors not wanting to invest in bonds in a low-interest rate environment. Another potential detractor is that in a low rate environment, rates have much more room to move up than down (since rates are nominally bounded by 0%). If interest rates rise, the market price of bonds will fall, causing losses among bond holdings.

Key Takeaways

  • Bonds are debt securities issued by corporations, governments, municipalities, or others; they are considered to be lower risk and lower reward than stocks.
  • In low-interest rate environments, bonds may become less attractive to investors than other asset classes.
  • Bonds, especially government-backed bonds, typically have lower yields, but these returns are more consistent and reliable over a number of years than stocks, making them appealing to some investors.

Risk and Reward in the Financial Markets

Many investors are more attracted to the potential double-digit returns that the stock market can produce, which are not seen as often in the debt market.

Despite the perception, the bond market can be very profitable for investors, as investing in bonds is considerably safer than investments in the equities market. The safety and consistency of bonds have value, particularly when bond investing is used to balance or offset riskier stock holdings. It is often not until after an investment in the stock market goes wrong that investors realize how risky stocks can be. The underlying concept of this idea is the willingness of an investor to take on risk to reap a potentially greater reward.

This is one of the most basic tenets of the financial markets—the more risk you take on, the greater the compensation you need to receive. Investing in the stock market is considered to carry more risk than the bond market and, therefore, it generally provides greater returns for investors in the long run.

Stock Returns vs. Bond Returns

It is the impact of these greater returns on a person's investments that affects the investment that a person will choose. For example, imagine that you were able to invest in the bond market and earn 5% on your initial investment of $10,000 every year for 30 years. In this case, your investment would grow to $43,219. On the other hand, if you were to invest in the stock market, which provides a higher return of, say, 10%, that initial $10,000 would grow to $174,494 or just over four times as much (20% would get you $2.3 million).

The possibility of earning a significantly higher amount of money certainly influences investors to place their money in the stock market. It is important to note, however, that a 10% return on stocks is far from guaranteed and there remains a potential for loss. Nevertheless, it is the prospect of huge gains over time that draws some people away from the bond market and more towards the stock market.