Last year, one of my clients asked me this question. He was well-educated, but had simply never had an occasion to learn how investments work. It struck me at that moment that if he didn’t know, then plenty of other people probably don’t, so I decided to prepare a short introduction to the topic.
Simple questions don’t always have simple answers, and a complete answer to this question would not be simple. But here is a simple description of the basic difference between stocks and bonds:
If you own a stock, you are one of the owners of the business that issued the stock.
If you own a bond, you are a lender to the business that issued the bond.
Companies issue publicly-traded stock when their business activities require funding that cannot be obtained privately. In return for the funds received in the initial sale of stock, the corporation grants ownership. Once the shares trade publicly, shareholders can sell their shares to others at a price determined by the marketplace.
Suppose you bought stock in (fictional) TidyPooch, Inc., a relatively small, struggling company that provides dog grooming services. Let’s say that there are one million shares of the company in existence and that these shares constitute total ownership of the company. In that case, each share of stock represents a one one-millionth ownership in TidyPooch (stock symbol WOOF). If you are fortunate enough to own 500,000 shares of WOOF, you own half the company. Depending on what the company decides to do with its after-tax earnings each year, you might be entitled to a dividend.
The price of the company’s stock is determined by the marketplace. If stock buyers believe that business will be good, they will bid up the price of WOOF. If the current price of the stock is $1.00, then the total value of all the shares is $1,000,000 – this is called the stock’s market capitalization. The market capitalization represents what the marketplace believes the whole company is worth.
Occasionally, you will hear stocks referred to as equities; this simply points again to the fact that stock shares involve ownership.
Another way for TidyPooch to raise money to invest in its business is to borrow it. It could simply approach a traditional lender, like a bank, in order to borrow money. Alternatively, TidyPooch may borrow money by issuing bonds in the open market. In practice, companies do both, making use of all the sources of capital available.
Bondholders, unlike stockholders, do not own the business. They are only entitled to have their loan repaid according to the specific terms of the bond. Bond repayments work differently from the way that a mortgage is paid off, in which each payment contains both principal and interest amounts. Instead, a bondholder usually receives periodic interest payments on a regular schedule, and then on a specified date, the initial investment (the principal) is repaid. If everything goes as planned, the bondholder has received a steady stream of interest income.
Like stocks, bonds may be traded publicly. Once a bond has been issued, a bondholder might decide to keep it for the duration of the loan, or might decide at some point to sell the bond to someone else. The pricing of bonds can be complicated; the price will depend on the company’s creditworthiness, the way that interest rates have changed since the bond was issued, the duration of the loan, and other factors. If a company’s profits are down but it has lots of cash on hand (think of Microsoft, for example) the price of the stock might drop, but the bond prices might not, as long as it looks like the company can repay its debt.
Aren’t Stocks Always Riskier than Bonds?
People generally think of stocks as risky investments and bonds as relatively safe ones. This is an understandable oversimplification of the reality. In a sense, stocks are riskier because if a company’s business fails and the company is bankrupt, the stockholder owns a bankrupt entity. Stockholders are not personally liable for the company’s debts, but if the company’s liabilities exceed its assets, the stock represents ownership in a business with a negative net worth. Unless there is some prospect for continuing the business and recovering from bankruptcy, the stock of such a company is essentially worthless.
In contrast, a bondholder is a creditor. Depending on the nature of the bond, a bondholder may have priority over many of the company’s other creditors if the company is forced to sell its assets in bankruptcy. Shareholders, by contrast, are the last in line in this scenario; they stand little chance of getting anything back unless the company is able to recover.
At first blush, then, stocks look riskier than bonds. But it’s more complicated than that when you start looking at specific comparisons. A bond issued by ExxonMobil – a large multinational company with lots of cash and assets – is not nearly as risky as a bond issued by, um, TidyPooch. In fact, TidyPooch’s stock might be only slightly riskier than its bonds, depending on the company’s business prospects and creditworthiness. But if you’re comparing the stock of one company with the bonds of another, buying TidyPooch bonds would expose you to more risk than buying ExxonMobil stock.
There is another sense in which a stock can be said to be riskier than a bond. If a company is basically sound, a bond represents a known cash flow to the bondholder; the income stream is known and predictable. The stock of the same company could easily drop suddenly in value and remain undervalued for months or years. A bondholder of the same company could continue to receive interest payments and might be able to sell the bond without a loss.
In practice, bonds issued by companies with poor credit pay higher interest rates than those issued by strong, stable companies, and that’s not too surprising. Companies, like people, receive credit terms that depend on the strength of their prospects for repayment. Perhaps you have heard of junk bonds; a junk bond is a bond from a company with a poor credit rating. Ideally, an investment should always offer the prospect of a higher yield in return for a higher level of risk, so junk bonds pay higher returns than bonds issued by companies that are highly-rated..
Since bonds are generally more complicated than stocks, I need to say a bit more about bonds in order to fill out the picture of the differences between the two.
While stocks are issued only by corporate entities, bonds can be issued by anything with the authority to borrow money. In the open bond market, the most common non-corporate bonds are issued by municipalities, state, or federal governments. The best-known debt securities are those issued by the United States Treasury. Under normal circumstances, Treasuries provide the lowest bond yields, in keeping with the perception that they are the least risky bonds to own. The government has the power to raise money to repay its debts through taxation and fees. Foreign companies and governments also issue bonds.
Since bonds involve financing a debt, bond terms can vary widely. The most common variation is the length of the loan. It can be as short as days, or as long as years. Normally, longer-term debts offer higher interest rates, though there can be exceptions to this.
Bonds can vary in their seniority. Seniority determines where a bondholder stands in line in the event of a default; the more senior the bond, the higher the bondholder’s priority for getting repaid if the company goes bankrupt. A bond can also be secured by a physical asset, the way that a mortgage is secured by a home. If there is a default, the secured bondholder has an ownership claim on the asset.
Bond provisions can also involve all sorts of other specifications. The terms of the bond can specify
how frequently interest will be paid,
the currency in which interest will be paid (it doesn’t have to be dollars),
whether the interest payment is fixed or variable,
whether the company can decide to pay back the principal before the specified period,
whether in the future the bonds can be exchanged for the stock of the issuing company, or
a myriad of other possible twists and turns too varied to discuss in a short educational blog post.
As you can imagine, all of these factors can affect the market price of a bond, and as markets and circumstances change, different terms can make a specific bond more or less attractive to a potential buyer.