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
|Nature||Bonds are loan obligations of a borrower that pay interest and principal on a specified schedule while restricting participation in the profits.||Stocks represent the ownership interests in a company and entitle holders to receive dividends and participate in long-term company growth.|
|Risk||Bondholders usually have priority on claims against the assets of the business to recover interest and principal.||Stocks assume the entire risk and there is no guarantee of repayment of capital once invested. Any proceeds remaining after paying all creditors are what equity holders receive upon liquidation of the company.|
|Management Control||While bondholders impose restrictive covenants on the company, they have limited control on management actions and can’t influence the operations of a company.||Equity shareholders can elect the management of the company and have a significant influence on the strategic direction of the company, commensurate with the number of voting shares they own.|
|Returns||Depending on the issuer (borrower), bond investments are mostly safe, especially in the case of investment-grade and sovereign issuers that have a low probability of default assigned on interest and principal payments.||Equity investments have no guarantee on returns as price movements and dividend payments influence the return profile of the investment. The historical track record of dividend payments can inform investors of future payments.|
|Notionals||Bond markets are dominated by institutional investors and minimum bond investments during the primary issuance process are in the millions making the market less accessible to retail investors.||Equities can be owned in smaller quantities and fractional ownership is also possible with most investment platforms making equity markets easily accessible to the retail universe.|
|Market Size||Fixed income as an asset class is significantly larger than equities and attracts larger market participants that are looking to express global macro views of various economies.||While new investors are attracted to equities as they get the most coverage from financial media outlets, equity markets are smaller than fixed income as an asset class and take cues from other asset classes for direction in volatile trading conditions.|
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.
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.
Did You Know?
Tesla’s Elon Musk turned up with a takeover bid for Twitter to take it private at $54.20 per share and built a holding position to force changes in management of the firm.
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.
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
- Why would someone buy bonds instead of stocks?
There are several reasons to initiate fixed-income positions in periods of low growth and economic slowdown as a recession or an economic contraction looms. Further, institutional asset managers such as life insurance companies or pension funds have long-dated liabilities that match bond return profiles, facilitating liability-driven flows.
- Are bonds less risky than stocks?
Bonds hold less risk than equities of the same issuer, but a general statement encompassing all bonds is hard to make. Government bonds issued by large G10 governments usually have a very slim chance of default, making those bonds almost risk-free.