What is the difference between stocks and bonds?

Shares of stock represent a personal or business interest in the success of a corporation. Bonds represent companies issuing a long-term debt with the agreement to pay a principal amount on a specific date in order to borrow the money. Typically, a bond contract is set on a fixed interest payment which has to be made every six months.

By purchasing stocks, you can receive monetary payment when a company declares a dividend. Bonds, on the other hand, represent debt from an entity that needs to raise cash in the public market. Stocks represent an ownership stake in a corporation or other business entity.

Investors will purchase stocks or bonds to create a financial portfolio. Every corporation has a common stock. Some corporations even issue preferred stock.  Yet many corporations do not issue any bonds.

Stocks and bonds issued by large corporations are frequently traded on stock and bond exchanges. Stocks and bonds of small corporations usually are held by investors and not traded on an exchange.

bonds

Initial Public Offering

If a company has made it successfully through its start-up phase, as a result they can turn to financial markets for more financing. The way this is done is by splitting the company into ‘shares’. These shares are now on the open market through a process called ‘initial public offering’, or also known as IPO. People, who buy these shares or stocks, are in actuality buying a part of the company and now are known as part owners. For this reason, stock is also known as ‘equity’.

Bonds do not carry long-term potential like stocks, but for investors for whom income is a priority bonds are preferred. Bonds carry less risk than buying shares or stocks.  The market fluctuates constantly, yet the vast majority of bonds tend to be paid back in full amount at the time of maturity.

Diversify

Investors will diversify their portfolios between stocks and bonds to balance risk. There is always a risk factor associated with investing into a company should the company go belly up or merge. If the company doesn’t do well and increase its value over time this can be a loss. At the same time, if the company performs well, much of the profits go to those who own the stocks. The overall stock market carries risk in the wide spectrum of volatility. The investor could profit or lose money in a relatively short time.  This is called a short-term risk.  Risk is minimized with long-term risks, waiting for an established company’s value to rise.

As an investor, many will base their investments on three things: time horizon, tolerance for risk, and investment objectives. Here are the key factors of stocks and bonds:

  • Priority of repayment. Should the company have to liquidate their business; the holders of its stock have the last claim on any residual cash, whereas the holders of its bonds have a higher priority, depending on the terms of the bonds. Stocks are a riskier investment than bonds.
  • Periodic payments. A company has the option to reward its shareholders with dividends, whereas it is obligated to make periodic interest payments to its bond holders for specific amounts. Some bond agreements allow their issuers to delay or cancel interest payments, but this is not a common feature. A delayed payment or cancellation feature can significantly reduce the amount investors will be willing to pay for the bond.
  • Voting rights. Those who have stocks in companies sometimes can vote on certain company issues, such as the election of directors. Bond holders have no voting rights.

Example of a Bond

Let’s say you have a bond value of $1000 and pays a bond certificate. A $1000 bond with a 4% coupon would pay $20 to the investor twice a year ($40 annually) until it matures. Upon maturity, you would be returned the full amount of your original principal except for the rare occasion when a bond defaults (the company is unable to make the payment). Bankruptcy is not the word investors ever want to hear. This is how risk plays a role in the loss of an investor’s money.

Variations on stocks and bonds share some similar features. Some bonds have conversion features which permit bond holders to exchange their bonds into company stock at certain predetermined ratios of stocks to bonds. This option is preferred when the price of a corporate entity or company stock rises, allowing bond holders to receive an immediate capital gain.

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