For prospective investors and many others, it is important to distinguish between bonds vs stocks. Two of the most common asset classes for investments are bonds, also known as fixed-income instruments, and stocks, also known as equities.
Both types of investments have a deep history within the capital markets. To understand which investments are more suitable for the individual investor, one must understand what the securities are, the return that they provide, and the risk that they carry.
What are Bonds?
Bonds are debt instruments and can be considered IOUs or loans. The basic idea behind a bond is that an entity needs to raise money, and therefore, can sell a bond in return for the required funds. In return, they promise to pay back the initial amount that they borrowed, in addition to interest. Interest represents the compensation rate that the investor, who is the lender in this situation, requires.
They are also called fixed-income instruments because they provide a fixed amount of return, which comes in the form of interest.
What are Stocks?
Stocks are equity instruments and can be considered as taking ownership of a company. While bonds are issued by all types of entities – including governments, corporations, nonprofit organizations, etc. – stocks, on the other hand, are issued by sole proprietors, partnerships, and corporations.
The basic idea behind a stock is that an entity needs to raise money and can sell stocks or shares in return for the required funds. In return, the company gives the investor a portion of ownership in the company, entitling them to excess earnings, and enabling them to make ownership decisions, such as voting on management.
In contrast to fixed-income instruments, stocks do not provide a fixed amount of return; in fact, the return that they yield can fluctuate very significantly.
Practical Example – Bonds vs Stocks
Suppose there is a lemonade stand that recently opened. The founder of the lemonade stand is receiving much more demand than anticipated and wants to take advantage of the situation by opening a second lemonade stand. The second lemonade stand will cost around $1,000 to get up and running. However, the founder does not have money on hand to fund the second lemonade stand even though he knows it will be successful.
The founder can go to various investors and pitch the success of his business to the investors in order to raise money for the second lemonade stand.
The founder can raise money through a bond, by borrowing $1,000 from investors and promising to pay back $1,000 in five years plus an additional 5% interest. The founder is hoping that the lemonade stand will be successful, and he will be able to make more than $1,050, so he can pay back the loan plus interest and keep the excess for himself.
The founder can also raise the funds through a stock by issuing 40 shares to himself and selling 10 shares to other people for $1,000. Each of the shares represents ownership of the company. Therefore, the 10 shares sold will be entitled to 20% of the future earnings (10 shares issued / 50 shares total).
The shareholders are entitled to 20% of all of the lemonade stand’s future earnings, but the founder does not need to pay back the initial amount raised from investors, which is in contrast to bonds.
If the lemonade stand goes bankrupt, the founder would owe money to the bondholders first, before receiving anything himself. It is because bondholders have seniority and extra protection from bankruptcy risk.
Where to Buy Stocks and Bonds
Stocks are well known for being sold on various financial exchanges – in the United States, the most popular exchanges are the New York Stock Exchange (NYSE), NASDAQ Stock Market, or the American Stock Exchange (AMEX). In Canada, the main stock exchange is the Toronto Stock Exchange (TSX), and in Europe, there is the Euronext and the London Stock Exchange.
Stocks are issued initially through an Initial Public Offering (IPO), and can subsequently be traded among investors in the secondary market. Stock markets are tightly regulated by the Securities Exchange Commission (SEC) in the U.S. and are subject to tight regulation in other countries as well.
Bonds are not sold in central exchanges. Instead, they are sold over-the-counter (OTC), which essentially means that they are traded among individual brokers from buyers and sellers, instead of on a centralized platform. It makes bonds much more illiquid, and more difficult to buy and sell relative to stocks.
Pros and Cons – Bonds vs Stocks
Stocks are beneficial for investors who have a higher risk appetite. Stocks are much more volatile, and there is a higher chance of losing your investment since equity holders are subordinated to debt holders if a company is forced to liquidate. However, in return for the risk, stockholders have a greater potential return.
Bonds are more beneficial for investors who want less exposure to risk but still want to receive a return. Fixed-income investments are much less volatile than stocks, and also much less risky. Again, as mentioned earlier, stocks are subordinated to bonds in the event of a liquidation. However, bonds have a lower potential for excess returns than stocks do.
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