Have you ever wondered if it is safer to invest in bonds or stocks? Many people think that bonds are less risky because bonds pay a fixed income at regular intervals, and stocks are a type of ownership into a company and are not obligated to pay anything.
Let’s dive deeper and see if this principle is true or not? But, first, we need to learn a little more about both bonds and stocks.
What are Bonds?
A bond promises investors that it will pay a certain amount to the purchaser over time and return the bond's original price on a certain date. The bond money allows the funds used however they want to, as long as the interest gets paid back to the purchaser and the initial investment.
If a company defaults on the bond by not paying the interest, bondholders can garnish the company's assets. Stockholders cannot get paid a cent until the bondholders have received their money.
Companies have to meet their interest payments on time or risk having the investors secure their assets to recover their investment in the bonds. Stockholders do not have any guarantee of money getting paid to them.
Under bond purchasing, investors can place the company under restrictions to tell them how to use the money. These are called “covenants.” In addition, bondholders use covenants to keep companies from wasting the money invested in them.
The volatility for bonds has a minimal to low risk compared to a much higher volatility rate for stocks.
Companies with large debts will often offer the sale of bonds to help alleviate their debt by creating security bonds.
Bond prices are usually determined by demand.
How Do Stocks Differ from Bonds?
As previously stated, when you buy stocks, you are paying for ownership of that company.
Unfortunately, just like when you or I start a business, there is no guarantee of getting a return on your investment. The company you invest in may decide not to give any dividends.
Another scary thing about stocks is that your investment value can change day by day, dependent on the company’s business profits.
If you are a company, stocks are safer than some other ways to fund your business. Although payouts are not mandatory, the company is protected from having its assets taken or possibly bankrupting as easily.
Although the corporation is not required to give investors dividends if the company is run well, investors should see a capital gain over time.
Stocks can gain a virtually endless amount of profit if things go well, but just as quickly can lose everything in a short while. Bonds, however, have a relatively low potential for growth and are fairly fixed as to how much change you can expect.
With bonds, you can lose everything but may get at least some of your losses back. You become an owner in the business when you buy a stock, but with bonds, you do not.
Other Differences Between Bonds and Stocks include:
As we dive further into stocks and bonds, we will see that both have advantages and disadvantages. You will not find the answers to all your financial needs in either one necessarily.
More Disadvantages of Bonds
Many people buy bonds or invest in stocks to prepare for the future unknowns and help stabilize their income needs when the economy is doing poorly.
One of the problems we see with depending on bonds for this is that the amount of profit from them often is not even enough to help with the cost of living increases we see most years.
Typically you will get a profit of no more than 4% from a bond. Some years the cost of living can go up to 3% or more.
When this happens, the gain from bonds will barely break even and cover that at 4%. This rate does not help your purchasing power. If it rises above 3%, you may even lose purchasing power.
Occasionally, companies go bankrupt, and their assets are sold to pay off a portion of their debts. Although rare, if this happens, you will not be able to recoup much of your investment.
More Disadvantages of Stocks
One major disadvantage of purchasing stocks is if stock prices do not rise, then you risk getting no gain at all on your investment.
Even if a company gives dividends to its stockholders, it can always be cut or even taken away entirely since it is never promised when you buy stock.
If a company does cut its dividends, it usually makes stock values drop, which leaves investors with a lower cash payout and a capital loss.
Stocks often fluctuate as much as 50% in any given year, making it hard for newer inexperienced investors to know when to buy and sell their stocks.
Ownership Versus Creditors
When trying to figure out stock, it can help think about the role stocks play in a business compared to a bond. Companies who are trying to raise capital will often sell equity or ownership into it. These are called the shareholders.
Bondholders are more like creditors because the company has asked investors to lend them money by purchasing their bonds at a fixed price with a certain amount of interest to be agreed to pay back.
When you own something, no one has to give you money to own it. You usually pay out more money over time with expenses for upkeep and whatnot.
As shareholders, unless you receive dividends that are not promised, the only way to recoup your cost is to sell off your part of the ownership by letting someone else take over ownership.
That is how we see a gain or profit.
If you buy a house and pay your payments on time, take care of the maintenance on it for years to come if all goes right, when you sell it, you will not only get your cost back and hopefully have a gain depending on the housing market and other factors.
In the house scenario, the bondholders are your mortgage company or bank that financed the loan for it.
Both can give you a profit or gain when things are going well, but both can also bring a loss under other circumstances.
For the business, a loss might come if the management is poor, or if the product is inferior, or competition is too stiff. Job losses, damages to your home beyond your control, and income setbacks could all bring a loss to your gain from your house.
Natural disasters can affect both.
So hopefully, you can see from this house illustration what part shareholders and bondholders play in whether a company succeeds or not and if they will get a gain on their investment.
Which is Risker for the Investor, Stocks or Bonds?
When inflation rises, the price of bonds can be hurt unless the central bank helps deter it. Since bonds have a set amount of payments built into them, they do not rise in price like stocks can when inflation gets high.
Instead, inflation brings down the value of bonds, making them less valuable.
Companies that have stocks can help maintain stability by raising the stock price when inflation gets terrible. This action helps them retain a profit even in times of higher inflation.
Bonds may seem less risky, but their lower profit gains do not increase purchasing power very much.
Stocks can often offer more purchasing power at retirement than bonds because they offer a higher gain on the investment.
Like bonds, stocks are priced based on demand. So, if demand for a particular stock drops, then the price will go down.
Stocks often decline in price rapidly when there is a market sell-off. Usually, this happens because investors think that interest rates may be declining. Bonds, on the other hand, may become more valuable in this scenario.
Should You Own Both Stocks and Bonds?
Investing in both stocks and bonds is one way to have a diversified portfolio. Why would you want a diversified portfolio? Diversification helps keep investors increase their gains.
Diversification is not for everyone, but it helps them enjoy the benefits from both whiles alleviating the less desirable aspects.
Having both stocks and bonds can help balance out an investor's individual needs over time, making it an excellent option for many.
If an investor has some bonds in his portfolio and then decides to purchase stock, a common pulling back before each helps keep your portfolio more balanced than having just one or the other.
A Strategy of Diversification
Since some days your stocks may have a price drop, having a mixture of bonds mixed in your portfolio makes for a safer option. The same applies if your bonds fall in price. The stocks can help you to ride out any financial crises that pop up.
Bonds having a schedule helps buyers approximately know when they should receive an interest payment on their bond purchase.
Stocks usually yield much higher profits but may take even years to reach enough to sell them for a gain. Part of the reason is that stocks go up and down so much in any given year.
Three Things to Consider Before Making any Investment:
What Happens if a Company You Buy a Bond From Goes Bankrupt?
If a company that you buy bonds from goes bankrupt, you may lose everything, much like stocks. However, bondholders do have some recourse as they can seize assets to get at least a portion if not all of their money.
Bondholders can collect money before stockholders in a scenario of a company going bankrupt. However, bondholders are not the first people who will get paid out from a company's assets in the event of a bankruptcy.
People who have extended credit for supplies, products, and services may fall under “liquidation preference” in the event of a bankruptcy.
A liquidation preference is a built-in clause in a contract that specifies who will get their portion of assets recovered in bankruptcy. These are often part of investors who commit venture capital to a new business contract before investing in a new business.
New businesses have around a 20% failure rate in their first year.
To protect themselves from huge losses, venture capitalists usually have a clause in their contracts when they finance these new companies to get paid first in the event of a bankruptcy or foreclosure.
However, taxes and creditors generally get paid before preferred stockholders or common stockholders. Preference is given to early shareholders in a company, then the rest preferred and common after that.
If you look at all the facts, it would seem they are about equal in many ways as far as a possible risk. Bonds can still be a complete loss under the right circumstances, just like stocks.
However, stocks fluctuate a lot during the year and can be rather stressful if you are the type of person who panics easily. Stocks give a much higher return usually on your investment, while bonds have a tiny percentage of gain on average.
Perhaps, it depends on which is safer on the unique circumstances of each business. You will have to decide if the risk is worth the possible increases in the end.
Perhaps you are better off investing some of each to give you a better chance at gaining a profit in the end.
Whatever your strategy, take a careful look at the possibilities and decide if the risk is worth it.