Stocks vs Bonds: What’s the Difference?

The main difference between bonds and stocks is that bonds represent debt obligations while stocks are tied to ownership of an entity.

Differences Between Bonds and Stocks

1. Nature of Investment

Bonds represent debt obligations of an issuer that are backed by interest and principal payments paid on a predetermined schedule.

Such an investment does not allow bondholders to participate in any upside and protects the downside by securing bondholders as the first claimants on the assets of the company.

Equity investments in a company’s shares represent ownership in the company and its earnings, growth prospects and participation in decisions around the company’s management if you have the appropriate shares.

2. Risk

Bondholders have safety in receiving coupon payments and principal payments secured by the assets of the business.

Their risk is limited as they can impose restrictive covenants preventing management from taking on potentially dilutive debt and diverting cash from operations to enrich shareholders at the expense of bondholders.

Equity shareholders’ interests can be discharged by the residual assets left after paying off creditors and discharging liabilities of the company before returning any capital to shareholders in the case of a liquidation event.

Further, there is no guarantee of the payment of dividends to equity shareholders and they assume all risk of the business operation.

3. Management Control of the Business

Equity shareholders can appoint the management of the company via their nominated Board of Directors thereby exercising some degree of control on the company’s actions and operational strategies.

Such control can influence the future path of growth, and strategic partnerships that may unlock long-term value for equity investors.

These actions can advance the interests of the equity holders; yet, at the same time, they might not be the most favourable for bondholders.

While there are risks of management choosing an unprofitable expansion of operations, bondholders limit management’s ability to incur additional debt and maintain certain liquidity ratios to prevent potential default on a company’s debt obligation.

Such terms and conditions can be affirmative or restrictive in nature and are defined in the bond indenture document.

4. Returns

Bondholders are recipients of interest and principal payments despite how much free cash flow or profit the enterprise is generating.

While they have very limited ability to participate in the upside of the company, they are able to secure their interests by having a priority on the assets of the entity ahead of equity holders, making their returns less risky and adding a margin of safety to their investment.

Equity shareholders are not guaranteed any dividends and assume all the downside risk if the company were to go out of business.

On the flip side, they can earn significantly outsized returns as they get to keep all the net earnings after debt and tax payments.

This is the ‘reward’ for bearing the higher risk.

However, established companies in various mature sectors such as financials and utilities pay consistent dividends, reducing the downside of equity investing in that space.

5. Notionals

Fixed income investments are largely reserved for asset managers, pension funds, endowments, life insurance companies and large family offices.

Bond markets are dominated by institutional money and retail investors usually are unable to participate due to the lack of smaller ticket investing opportunities.

However, with the proliferation of fixed income exchange traded products, small investors can participate in larger credit and rates markets using low-cost funds to get necessary fixed income exposure to their portfolios.

Equity investments are easy to understand and a common entry point for most beginner traders that can track stock prices easily versus bond prices that are mostly traded over the counter.

Finally, fractionalization of equity ownership allows retail investors to participate in risk markets without outlaying large sums of capital.

6. Market Size

Fixed income markets attract larger asset managers looking to express views on the relative performance of the economy with the ability to also utilize leverage.

Market participants can be motivated for various reasons such as liability-driven investments for insurance companies and pension funds that have long-dated liabilities.

Equity investments can be less broad and attract a different set of market participants who may be looking at either capital gains or dividends as forms of growth.

Is it Better to Invest in Stocks or Bonds?

Any investment needs to be conducted with requisite due diligence of the growth backdrop and inflation expectations to identify how that asset class will fare in such a market regime.

Usually, stocks and bonds perform well in periods of low inflation and high growth as you’d expect, but bonds can outperform risk assets in periods of low growth, low inflation periods.

However, bonds struggle when inflation picks up.

Based on these characteristics, investors can benefit from having exposure to stocks and bonds while tactically managing underlying equity and fixed income holdings to make the most the present investing climate.

Bridgewater’s Ray Dalio has advocated for a risk parity approach to hold bonds and stocks to diversify and use appreciation in fixed income to offset losses in equities during periods of slowdown and volatility.

What’s The Difference Between the Stock Market and Bond Market?

The stock market primarily trades equity interests in publicly traded companies across different sectors of the economy such as energy, finance, technology, media and more while bond markets trade debt obligations of various issuers (governments, companies, provinces, municipalities, etc.).

Stock markets have advanced technologically over the course of time and most products are extremely liquid, have tight bid/ask spreads, are electronically traded and have a breadth of market participation amongst retail, fast money types and real money accounts.

On the other hand, bond markets have been swiftly embracing more technology in trading, but market participants are skewed towards larger, institutional accounts.

Further, it isn’t uncommon to still pick up the phone and call a bond trading desk to get quotes on different bonds that are not traded frequently or have limited circulation and holders.

It is a widely-held belief that bond markets sniff out changes in the economic landscape quicker and send signals that set off price moves in other asset classes such as currencies, commodities and equity markets.

What is a Bond?

Bonds represent a standardized contract between a borrower and a lender that agree on a coupon rate (also known as interest), a maturity date and a schedule of payments upon which the principal is paid back to the lenders.

There are other terms and conditions that stipulate actions a borrower can or cannot take, payment kind, claims on the borrower’s assets and more, which are known as covenants and are part of the bond agreement.

Bonds are issued by several institutional borrowers such as sovereign governments, sub-sovereign and supranational issuers (states/provinces/agencies), as well as corporate issuers.

What is a Stock?

Stocks represent the ownership interests in a company and entitle holders to receive dividends and participate in net profits.

Stocks assume the entire risk and there is no guarantee of repayment of capital once invested.

Stocks entitle the holders to vote to elect the Board of Directors and other matters affecting the corporate governance of the entity.

Most equities are publicly listed and are categorized by the market capitalization of the company.

Frequently Asked Questions