Stocks vs. Bonds: Understanding the Essentials

Apr 26, 2021 07:58 PM ET
Stocks vs. Bonds: Understanding the Essentials

Bonds and stocks are two major asset classes offering investors lucrative returns on different terms. While bonds are usually issued by governments, municipalities and large corporations as a means of funding their programs, stocks are small fractions of a large-, medium-, or small-cap company meaning ownership. We analyze why both assets are worthwhile.

Stocks

Stocks are issued by companies as a means of raising money to fund operations or expansion strategy. By selling stock, a company cedes part of its ownership to its shareholders. So, how do companies sell shares? Well, shares are floated to financial markets in form of Initial Public Offering (IPO) which involves selling a unit share at a fixed price to willing buyers. After the IPO, the shares become available for trade at Securities markets such as Nasdaq and NYSE.

The performance of shares/stock is usually tied to the performance of the issuing company. This means that the share/stock price increases when the company is doing well and decreases when the company is performing poorly.  However, stocks are often subjected to speculation, which may result in overvaluation or undervaluation of a company.

Types of stock

Preferred stocks

These are stocks whose owners get preferential treatment, so to speak. How preferential? Well, holders of such stock get regular payouts in the form of dividends. In case the company is liquidating, they will also get their cut depending on how many shares they hold.

The big difference with preferred stock is that its holders get a predetermined interest, unlike common stock. In addition, holders of preferred stock do not have the right to vote on critical company decisions. The common business practice is that preferred stock usually comprises a smaller percentage of the company shares. Many companies do not have preferred stock.

Common stock

This type of stock is the most popular stock issued by companies. With these stocks, an investor's earnings will be directly dependent on the profitability of a company. The advantage of this is that there is room to increase your profit margins every time the company performs well. The downside to this is the possibility of making huge losses if the company makes losses. However, as a common stockholder, you will have the right to vote on company decisions, which makes you a hands-on investor. The high-profit potential of common stock makes them more attractive than preferred stock.

Advantages of stocks

  • Stocks are generally easy to buy and sell for cash

  • Stocks can earn you high returns, multiple times your investment.

  • If you don't want to deal with the uncertainty of common stock, you can opt for dividends, which will earn you a more stable return.

  • Stocks are a good hedge against inflationary pressure on the economy.

Disadvantages of stock

  • The volatile nature of stocks makes them a risky investment.

  • Trading in stock requires a hands-on approach and significant market knowledge.

  • Brokers and traders will charge you a considerable amount of money, which may reduce your profits or even lead to net losses.

Bonds

Bonds are debt agreements reached between an issuer and a buyer on the understanding that the buyer will pay a defined amount of money which will earn fixed interests every year over a specified period, upon whose expiry the issuer will return the principal amount to the buyer. 

An example of a bond may be issued by the US Treasury, which may give a $10,000 par value bond with a 5% interest (or coupon) with a 20 year maturity period. This would mean that an investor who buys the coupon will earn $500 annually from the US government for 20 years, after which they will get back their $10,000. This means that at the end of 20 years, the investor will have earned $10,000 in interest from the government. Bonds are ideal, especially if you want to invest hands-free but still earn a fixed income. Bonds with longer maturity periods usually fetch higher interest (or yields) than short-term bonds.

In the case of corporate bonds,  investors can go for either investment-grade or high-yield bonds . Investment-grade bonds refer to bonds issued by companies with high credit ratings. They have low-risk levels but have lower yields. The other type of corporate bonds are high-yield bonds, which refer to bonds issued by companies with low credit ratings. For this reason, the issuers usually give high interest rates to incentivize investors. Because of the high-risk levels associated with high-yield bonds, they are commonly referred to as junk bonds.

Advantages of bonds

  • Bond investments give investors peace of mind since their yields are known beforehand. You can therefore plan better with them.

  • Bond holders are at a safer place in case the issuer faces financial challenges and has to liquidate. In such instances, they will be paid ahead of stockholders.

  • Rating of bonds places investors in a great position to assess the risk levels they are exposing themselves to.

Disadvantages of bonds

  • They return comparatively lower earnings than stock.

  • Some bonds can prove difficult to sell.

  • When interest rates rise, bond yields in the market fall, and vice versa. This may at times place bonds at a disadvantage.

What investors look at

As discussed above, owning stock exposes investors to potentially high profits as well as possible loss-making. This is because stocks are tethered to the performance of companies. On the other hand, bonds are less susceptible to volatility, but cannot earn such high returns as stocks. In addition, bond markets may at times move within wide margins, creating unpleasant fluctuations. Nonetheless, earnings from bonds are often almost certainly assured, except in unfortunate circumstances when the issuers are forced to liquidate. These are the key factors that investors have to evaluate before investing in stocks or bonds.

1. Equity and debt

Shares give investors the chance to own a piece of a company. If it's a company whose prospects are good, being a part-owner is definitely a good call. In the case of bonds, your money will be in a debt market that promises fixed returns. If your risk tolerance is low, bonds are the way to go.

2. Fixed income and capital gains

Stocks will yield you profit for as long as you hold on to them and the issuing company remains profitable. However, beware that you will have to pay taxes on your stock's capital gains. You also risk losing your money if the company goes under. For bonds, you will earn interest/yields on your money at fixed rates over a fixed period. Government-issued bonds are usually tax-exempt.

3. Inverse relationship between bonds and stocks

As cited above, bonds are comparatively low-risk while stocks are high-risk. For this reason, investors usually use one to hedge against the potential shortfalls of the other. This is also a way of optimizing profits and balancing investment portfolios. For this reason, often when stock prices rise, bond prices fall, and vice versa.

4. Trading on different platforms

Bonds and stock are offered on different platforms. If you want to own a stock, the securities market is the place to go. If, however, you want to buy bonds, you'll have to contend with brokers appointed by the bond issuer. Bonds are, therefore, said to be bought over the counter. This makes the process of obtaining them a bit complicated.

Bottom line

Bonds and stocks are both viable assets to invest in. However, they both have their strengths and weaknesses. Stocks have the potential to yield higher returns but also increase exposure to potential losses. Bonds, on the other hand, have lower returns but are generally safer. Investors should therefore weigh these risks before committing their money to either. It is therefore advisable to have a mixed portfolio, with a good balance between bonds and stocks.


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