What is the difference between investing in stocks and bonds?
October 14, 2022
Is it better to invest in stocks or bonds? Difficult to give a good answer without knowing what they are and evaluating their differences. Let’s do so together, starting with the definition of primary financial instruments and asset classes.
Primary financial instruments: stocks and bonds
Financial instruments are investment products that open us up to possibilities of profit, thus some choose to include them in the management of their personal finances. They can be divided, first of all, between primary and derivatives. Essentially, primary financial instruments have a value that does not depend on other instruments, a characteristic of derivatives. Stocks and bonds are primary financial instruments and also give their names to the corresponding asset classes.
An asset class is a group of financial instruments with similar characteristics that behave similarly in the market.
Stocks and bonds are issued (created) by economic actors who want to raise resources to finance their businesses. In principle, companies large and small, all the way up to huge state coffers, have two options to raise capital. They can either borrow from banks, commercial or central, or accept investments from ordinary savers. The latter are more advantageous than bank loans, because of the lower interest rates companies have to pay as a premium. Therefore, investing in stocks and bonds allows the underlying companies to expand, or at least to sustain their production processes, and rewards investors with a financial return in the event of success.
But what are stocks and bonds exactly? What are the differences between them, and how can you earn from these types of investments? Let’s find out in the following paragraphs.
Investing in stocks
To understand what stocks are, let’s take an example: Dunder Mifflin is a company that sells paper and office supplies wholesale. It has many customers and its services are in high demand. However, the company does not have enough means and resources to meet the high demand for its products and services. It needs financing, so it divides the value of its entire company capital (consisting of what it owns, including buildings and machinery) into shares: i.e. representative shares of ownership. There are several ways to issue shares, the most common is to organise an Initial Public Offering (IPO), the company will then become a public limited company (p.l.c).
Now, anyone who wants to participate in Dunder Mifflin’s economic enterprise can gain direct exposure to its performance by becoming a shareholder. Investing in stockss means sharing in the company’s losses and gains as reflected in the share price. Shares are therefore called ‘risk capital‘. They are rewarded precisely due to the uncertainty of the investment. Any profits from investing in stocks come from two factors:
- Buying and selling in equity markets: shares can be freely traded in markets such as the US stock exchange and Nasdaq, in order to make a profit from sales. The price of shares varies according to supply and demand, managed within online platforms called stock exchanges such as those just mentioned.
- Dividends are distributed periodically among the shareholders. Part of the company’s profits are shared proportionally among the shareholders, usually on an annual basis.
Shares effectively correspond to a percentage of the company, so whoever owns them should have the power to choose for the future of the company, essentially being a ‘partial’ owner. In reality, there are two types of shares, differing in governance powers and dividends:
- Ordinary shares (common stock): their market is very dynamic, holders can exercise voting rights but are not guaranteed to receive dividends. It is the board of directors (BoD) that decides whether and how much to distribute.
- Preferred shares (preferred stock): usually do not give decision-making power, but dividend payments are assured, which are higher than for ordinary shares. The market for preferred shares is almost static, because investors do not buy them for growth potential, but for regular profits.
Highly developed companies often do not distribute dividends because all profits are reinvested to expand the business. On the other hand, the value of their stocks has greater growth potential. Companies that have less room for innovation, on the other hand, pay high dividends: they may become a constant source of income, but their share value will not grow significantly.
If the company’s growth expectations are promising, investors will be willing to pay more for a share than its intrinsic value (fair value), based on the company’s capital. The company will then have the financing it needs to grow. So why are not all companies joint-stock companies? Issuing stocks is complex because it is strictly regulated, so many businesses prefer to sell bonds: let’s find out what they are.
Investing in bonds
The debt mechanism is the real pillar of the world economy. Companies and states often use borrowed money as ‘fuel’ for their production processes. Part of the value thus generated must then be returned to creditors, with a percentage of interest. However, credit institutions, banks and other financial institutions are not always willing to lend. They prevent the accumulation of excessive debt and, as already mentioned, sometimes limit it with high interest rates.
There is an alternative to borrowing: you can finance your debt through bonds, but what are they? In a nutshell, the company divides the capital it needs into many small parts, so that the debt can be ‘split’ among several creditors. Investing in bonds rewards through a mechanism similar to that of stocks, although the returns are different, as we shall see.
Each bond is created at a fixed value (called nominal), but could be sold at a different (issue) price. In short, creditors could buy a bond:
- below par, i.e at a discount;
- above par, i.e at a premium;
- par bond, i.e at par.
This is possible because bonds are often sold at auction. The highest bidder, at the end of the bond contract, will always receive an amount equal to the nominal value. If the price he or she paid at issue is less than that value, the creditor will make a profit (capital gain), net of any interest. This is the only yield returned by so-called zero-coupon bonds, i.e. with no further interest for the creditor; when present, these are called coupons.
The first bond contracts were paper-based and therefore physically equipped with a coupon, which you would then detach and take to the bank to collect the interest.
Coupons work similarly to dividends: they are periodically distributed among creditors, according to an interest rate that can be fixed or variable. Like stocks, bonds can also be sold on the secondary market (debt market), before the actual maturity of the contract. Corporate bonds are not the only type though: there are also state debt securities, or government bonds, i.e. issued by a national state, such as the UK.
Investing in government bonds
Governments issue government bonds to finance (or rehabilitate) public debt: these bonds tend to be safe, because the failure of a state (default) is rare.
However, different government bonds do not have the same level of risk: investing in government bonds of an emerging, economically unstable country gives higher returns than for example a German bond. This is because investors’ interest derives precisely from the level of risk they are willing to take.
Who rates the risk profile of a state? There are dedicated rating agencies, such as Standard & Poor’s, Moody’s and Fitch, which assign a ‘grade’ (AAA to D) to the solvency of a state, i.e. the probability that the principal will be returned to the creditor at the end of the bond contract.
The spread (differential) is the difference in yield between two bonds or stocks of the same type and duration, where one of them is the reference security. For example, to calculate the spread of Eurozone government bonds, reference is made to German bonds, due to their economic strength.
The European Central Bank itself (like the US Fed) buys government bonds to inject liquidity into struggling economies. It is a process called quantitative easing, adopted during the pandemic, which the ECB combines with the creation of new fiat money.
Once the economic recovery has been triggered, central banks gradually cease economic stimuli. This is because quantitative easing, if prolonged, could excessively increase inflation.
Stocks and bonds: differences
The main difference between stocks and bonds lies in the levels of risk: investing in stocks implies a higher degree of uncertainty. For the same reason it is also potentially more profitable than state and corporate bonds. In addition, the stock market exposes the company to the ‘psychological risk’ of investors, because a negative quarter could convince them to abandon the company. Moreover, in the event of default, companies and states repay creditors before shareholders.
Bonds guarantee the repayment of capital, whereas stocks do not protect the investment from business risk, although voting rights (if any) may influence the performance of the company.
There is no such thing as a ‘safe’ investment: financial instruments are not ‘good’ or ‘bad’; depending on personal goals, the investor will choose the most suitable one.