Accountancy Resources
Bonds and stocks are two of the most common types of assets purchased by investors and most portfolios include one or both. The two investment vehicles are very different, however, and this article will explain the differences.
Investing in bonds is essentially buying a portion of the debt held by a corporation, or sometimes government, and being entitled to the repayment of that debt plus any interest that may be earned. Companies borrow from banks and institutional investors all the time, and in turn, those groups then sell the debt to investors who want to buy it.
The risk with investing in bonds is that in some cases the debt can be defaulted on, in which case you may get nothing or very little if the company settles at a fraction of the face value.
Rating agencies like S&P and Moody’s provide ratings on companies (and their debt) in terms of the relative risk, ranging from junk bonds to very low-risk investment-grade bonds. The higher the risk associated with a bond the higher the interest rate will be, so there are tangible incentives to invest in lower-rated bonds.
When buying a bond you are typically entitled to two different cash flows. First, the face value of the bond when it matures will be paid to you. Second, any interest that is periodically paid on the debt will also be paid to you. This can provide investors with a schedule of fixed income over the life of the debt, as well as a relatively guaranteed final payment (assuming the company doesn’t default).
Putting money into investment-grade bonds is seen as a low-risk – low reward investment strategy and is suitable for investors who may be more sensitive than others to any losses (i.e. retirees). The low reward comes from the fact that interest rates are often low for high-quality bonds, so the returns compared to the potential of investing in stocks can be limited.
Investing in stocks, via the various stock markets, is purchasing a piece of the ownership of the companies that the stocks relate to. This will entitle you to participate in the future growth of the company and to any dividend payments that the company makes to shareholders.
The risk of investing in stocks is that if the company fails, or even misses analyst expectations, the share value can plummet and the base value of your investment will decline. The frustration for many in stock investing is that the value of the stock can vary greatly without any change in the underlying fundamentals of the company. This is because stock values are heavily influenced by expectations and what people ‘think’ they are worth. As such a single negative analyst opinion can sometimes send a stock price into a downward spiral, or the opposite can occur.
Investing in stocks, similar to bonds, generates two different cash flows. First, any dividends declared by the company will be paid to you while you are holding the stock. Second, any appreciation in the stock value through general improvement in the fundamentals or due to speculation can be capitalized on when selling the shares.
The stock market is generally a higher-risk investment vehicle than bonds. While huge gains can be made in a short period of time this comes at the risk that huge losses can be incurred as well. The high risk – high reward prospects of stock investing make it more suitable to those who can accept the risk (i.e. younger individuals).
The choice to invest in bonds vs. stocks comes down to risk tolerance and whether an investor can take the chance of losing it all to win big, or needs a slow steady stream of growth. Stocks are more suitable to higher risk tolerance, whereas bonds will be more appropriate to those that can’t afford the risk.
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