How Bonds are Different From Stocks

Summary:

Stocks and bonds are two types of securities which traders can purchase to invest in companies. This blog details their differences and explains what would suit each investor depending on their goals.

Introduction to bonds and stocks

Bonds are a type of debt security which represents a loan from an investor to the borrower (usually the government, a corporation or any other organization). When someone buys a bond, they are lending money to the issuer in lieu of periodic interest payments and the return of face value of the bond (known as the principal) when it reaches its maturity date.

In contrast, stocks, otherwise called equities or shares, are representative of ownership in a company. When somebody owns stocks in a company, they own a part or share of the assets and earnings of the company. By trading in stocks, individuals and institutions are able to invest in financial instruments to become partial owners of the publicly traded company.

Differences between bonds and stocks:

Stocks and bonds are two types of securities which traders can purchase to invest in companies. They have some key differences, which are listed as follows:

• Debt vs. ownership: Investing in stocks represents owning a part of the company. When someone buys stocks (equities or shares), they are shareholders and are part owners of the assets and earnings of the company. In some cases, they even have voting rights. On the other hand, bonds represent debt. When an investor buys bonds, they are typically providing finances to an entity (government or corporation). In return, they will receive periodic interest payments (coupon payments) and the face value (principal) of the bond when it matures.
• Risk and return: Stocks are usually considered to be riskier than bonds. The prices of stocks are highly volatile, and the value of the investment may fluctuate to a great extent over time. Stocks, however, have the potential for higher returns, including dividends and capital appreciation. Bonds on the other are considered to be less risky in comparison to stocks. The income that they provide is more predictable in the form of regular and consistent interest payments. Upon maturity, the full face value of the bond is received (unless the issuer defaults). Bonds though offer less returns than stocks.
• Income vs. capital appreciation: It is through capital appreciation that stocks provide returns. This implies that the value of the investment may appreciate over time. In fact, some stocks pay dividends, which is an extra income for investors. It is regular interest payments that generate income from bonds. Up until maturity, investors carry on receiving variable or fixed interest payments. Once the bond reaches its maturity date, the face value of the bond is paid. at which point they receive the face value of the bond.
• Safeguards in case of Bankruptcy: If the company is in financial distress or files for bankruptcy, bondholders have a greater priority claim on the assets and earnings of the company in comparison to stockholders. Bondholders are typically paid their dues before stockholders in such situations.
• Voting rights: Stockholders are sometimes entitled to vote on specific corporate decisions, which include electing board members and approving major corporate actions. In a way, they are able to influence the management and direction of the company. Bondholders usually do not have the right to vote. They are seen to be creditors of the company and are not required to participate in decision-making.
• Maturity of security: The stocks of a company do not have a maturity date and can be held indefinitely. There is no set date when the initial investments are meant to be given back. Bonds have a fixed maturity date when the issuer has to repay the face value of the bond to the holder. For investors who are keen on time-bound investment, a bond is the best way to go about it.
• Market volatility: The prices of stocks are affected by economic conditions, market sentiment and the performance of the company, implying that there are frequent fluctuations in the price. Even though the prices of bonds fluctuate at times, they are much less volatile in comparison to stocks. This is especially true when the bonds are high-quality ones of the investment grade.

Summing up:

In short, stocks are indicative of ownership in an organisation, making it possible to receive higher returns. However, they are riskier and more volatile than bonds. In contrast, bonds are a type of debt and give more predictable returns, with less risk. However, these returns are slightly less. Choosing between stocks and bonds will depend on the financial goals of the investor, along with tolerance for risk and expected investment horizon. For most investors, diversifying the portfolio by using a combination of both securities is the most common strategy to control risk and ensure higher returns. For the investor looking to dip their toes in both waters, this blog should be a good starting point.