How are bonds different from stocks?

Most investors have a good understanding of shares and how they work. A great way to frame a conversation about bonds is to leverage these familiar concepts to make bond investing easy to understand.

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Most investors have a good understanding of stocks and how they work. A great way to make bond investing easy to understand is to leverage these familiar concepts.

Bonds Versus Shares: Similarities and Differences

If investors want to invest in a company, they can choose to purchase its stock or its bonds. Both are a way for the company to raise money needed to fund its activities. The overall mix of debt and equity that the company uses is referred to as its capital structure.

If investors buy stocks in the company, they become part-owners of the company. If investors buy the company’s bonds, then they become lenders to the company.

There are several key differences between an investment in bonds and an investment in stocks, as highlighted in the table below.

SHARES (EQUITY) BONDS (DEBT)
Investment The investor owns part of the company. The investor lends money to the company.
Income The investor may receive dividends, which are paid at the discretion of the company and depend on company performance. The investor is paid regular coupons. The amount and timing of coupons is fixed and certain (provided the issuer doesn’t default).
Capital preservation The amount of capital the investor gets back depends on the share price when the stocks are sold. The capital is paid back in full to the investor at maturity. (provided the issuer doesn’t default.
Risk profile Generally higher Generally lower
If a company performs well Dividend payments may increase and the investor may benefit through an increased stock price. Coupon payments will remain the same and bondholders will receive back the agreed principal.
If a company performs poorly Dividend payments may decrease and the investor may lose capital through a decreased stock price. Coupon payments will remain the same and the investor will receive back the agreed principal.
If a company declares bankruptcy Stocks will become worthless and investors may lose 100% of their capital. As bondholders have a higher claim on assets, investors may still recover some of their initial capital but could lose all of their capital as well.

Let’s look at an example

A key difference between bonds and stocks is the predictability of returns, with bonds in general providing relatively more certainty. For example, let’s look at the differences between a $2,000 investment in a fixed rate 10-year bond with an annual couponof 5% and a $2,000 investment in stocks with a 5% dividend yield.

At first glance they look very similar, however there are two key differences.

  1. The value of the bond’s coupon payments is fixed at $100 per year, while the stock's dividend payment can differ each year.
  2. The upfront investment of $2,000 in the bond will be repaid at maturity, while the investment in the stock could be worth more or it could be less depending on the stock price.

The Risk-Return Profiles of Bonds Versus Shares

During recent decades, bonds have evolved into a $100 trillion global market. Not surprisingly, there is a wide range of bonds available, each offering different risk and return profiles.

Most bond investments, however, seek to provide regular income and capital preservation. As such, they are generally considered to be a lower risk investment when compared with stocks.

The chart below provides a high-level overview of where bonds fall on the risk and return spectrum relative to stocks and several other asset classes.

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Disclosures

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer's inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Diversification does not ensure against loss.  It is not possible to invest directly in an unmanaged index.

Hypothetical examples are for illustrative purposes only. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Investors should consult their investment professional prior to making an investment decision. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO
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