Investing in stocks is owning a part of the company while investing in bonds is owning a part of the company’s debt. This difference may sound intuitive and straight forward but it is far from it.
Both stock and bond are means of corporations to raise capital in capital markets. A stock is a financial asset which a corporation issues in order to raise capital by giving up a certain percent of ownership over the corporation. A bond is a certificate of debt issued by a corporation or country which is required, usually, to pay a fixed sum annually until maturity and a fixed sum to repay the Principal.
The basis for comparing both financial assets is derived from the aforementioned difference:
1) Risk and return – The most notable difference between stock and bond is the risk involved in the investment and, of course, the expected return. As a stock holder an investor is investing in the corporation’s future worth expecting it to grow. The corporation has not assured the investor in any way this scenario will take place. It is more then possible the corporation’s worth in the future will be lower. As a result of the risk taken stocks are expected to yield higher returns on investment. Investing in bond is investing in a company’s debt with the assurance of the company to repay the investor both the interest and the principal. The risk the investor is taking here is that of bankruptcy on the side of the company, a scenario in which the company will be unable to pay it’s debts. This risk, is of course, lower then that of the stock owner. As a result the yield on bonds is lower then that of stocks. For the same reason the return of government bonds is lower then that on corporate bonds (A government is more likely to make pay its debt to investors). There are further risks to investing in bonds besides the risk of bankruptcy:
a) Interest rates as a risk in bonds – As interest rates rise bond value decreases. This is a result of the fixed interest rate bonds carry (As payment is fixed it is discounted using a higher market interest rate).
b) Risk of falling ratings – Rating companies rate bonds issued by governments and corporations. In case the ability of the corporation to repay its debt is considered lower then it used to be the price of the bond will fall to express this added risk.
It is important to note that even though the risk portrayed in a. and b. above effect the price of the bond holding on to the bond until maturity guarantees the original yield expected at the time of investment.
2) Market Players – As bonds are mostly bought by institutional investors such as pension funds, insurance companies, mutual funds and banks the market for bonds is less volatile and less flammable. These bodies of investment usually have more conservative profit goals. This is one more reason why investing in bonds is considered relatively safe.
3) Term of investment – There is a conses among investors that for the short term an investment in bonds offers greater security and sometimes return. When considering long term investments (Over 10 years) stocks consistently outperform bonds (significantly).
To conclude, there is a proper place for both stock and bond in a portfolio depending on the risk one is willing to take, the expected return and the term of investment.