Stocks Vs Bonds : What Is The Difference?
In this article, we are going to do a comparison Stocks Vs Bonds and differentiate between them on the most fundamental level. There are two ways in which a company can raise capital, by borrowing money which is debt or by selling shares of itself or via equity.
A security is simply something that can be bought and sold and have a claim on something to have an economic value. So, a security in the equity market is a stock and a security in the debt market is a bond. Stocks and bonds are also the two main classes of assets which investors all over the world use in their portfolios. However, there are many types of stocks and bonds with varying level of volatility, risk and return, which leaves you with the most difficult job of selecting right financial assets in your portfolio. So, to construct a good portfolio that grows well over time, it is a very important need to clearly understand the differences between stocks and bonds as asset classes for investments.
Stocks Vs Bonds Comparison
Let see the difference based on the above mentioned points :
- Stocks are the equity instruments representing an ownership interest in a corporation and are traded on stock exchanges.
- Bonds are the debt instruments with a promise to pay back the principal amount with interest at a specific date and are traded on bond exchanges.
2. Who Are the Issuers?
- Stocks are issued by only companies who look to raise capital to use it for expansion projects and further grow the company or because the owner of the company wants a big lump sum of money for themselves as a reward for the hard work they have put in building the company.
- Bonds are issued by government institutions, financial institutions and companies etc. to borrow large sums of money for expansion, acquisition or other use.
3. Working of Shares & Bonds
- Here’s how shares work : Let’s consider a company who has made it through its start-up phase and has become quite successful. The owners of the company now wish to expand, but they are unable to do so on their own income that they earn through their operations. So, they can turn to the financial markets for additional financing. One way to do this is via stock market i.e. to split the company up into “shares,” and then sell these shares in the stock market through a process known as an “initial public offering,” or IPO. A person who buys Stock, is therefore buying an actual share of the company, which makes him or her a part owner – however small.
- And here’s how bonds work : When companies need money to fund their expansion, issuing bonds is the second way to do it. For better understanding, consider a bond like a simple loan. The investor agrees to give a specific amount of money to the issuer and the issuer pays regular interest (coupon payments) on it. At maturity, the total amount (loan principal) is paid back to the investor. Many companies chose bonds and not bank loans because the coupon payment is often less than what they need to pay on loans. Also, there are many limitations in case of bank loans but bonds give you a lot of flexibility to use the raised capital.
- Stocks pay dividends to the owners, but only if the corporation declares it. Profits earned by the company are paid in the form of Dividends to the shareholders of the comapny. When investors invest in stocks, they are more interested in the price growth potential of the stock/company ie. the capital appreciation in the stock price of the company.
- Generally, the bond contract requires that a fixed interest payment be made every six months or every twelve months. Interest payments are made in the form of Coupon Payments.
- Investing in stocks is much more riskier compared to bonds, as the returns are not guaranteed. Stock prices can fluctuate a lot over any time horizon and this volatility can decrease you share price to great levels. If you use leverage to invest in stocks, like buying on margin or short selling, you could even lose more than what you invest. So, for proper risk management, it is always recommended to hold a mix of stocks and bonds in the portfolio. Market risk, Business risk are the major risks associated with the stocks.
- Bonds are considered to be very low risk investment type, but not completely risk free. The most common risk is interest rate risk. If the interest rates in the country starts increasing, the bond prices will start falling. Since bonds are generally long term investment, inflation risk is also there as with the inflation, the value of money will decrease with time. Bonds also involve market risk, as with the economic conditions worsening, it may be difficult for companies to make coupon payments or even the principal payment at maturity, in the worst case.
6. Additional Benefit
Shareholders get the right to vote, while Bondholders get the preference in terms of Repayment and also on liquidation.
7. Traded Over
- Stock market has centralised place also called as stock exchanges, where stocks are bought and sold. Brokers do it on the behalf of buyers and sellers using a well-developed electronic system.
- Similar to the Stocks, Bonds are also traded over the exchages/platforms like NSE, BSE etc In the primary bond market, the entity that needs to borrow money invites the general public or investment banks to purchase their bonds. In the secondary market, the investors who had purchased the bond previously, sell their bonds to other investors. Various brokers operate in the secondary market who facilitate these transactions.