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.
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.
||The investor owns part of the company.
||The investor lends money to the company.
||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).
||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.
|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.
- The value of the bond’s coupon payments is fixed at $100 per year, while the stock's dividend payment can differ each year.
- 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.