KJ: With all of the headlines lately about the risks in the bond market with rising interest rates coupled with the fear in the stock market that prices are escalating too quickly, I thought it relevant to have a post outlining the very basics of stocks and bonds. Note that this is not a recommendation for either bonds OR stocks, but an understanding of the difference between the two. Let’s start with a summary of bonds.
In its basic form, a bond (a link to the Wikipedia definition) is an obligation of a company wherein YOU loan them money today (say $1,000 per person), so they can expand their operations, have the cash to fund ongoing projects, etc. with the ultimate expectation that they will pay you interest on your money (usually twice per year) and where they pay you the amount you loaned to them at the end of the “term” (as outlined in the agreement…say 1 year, 5 years, 10 years, etc). While there are a litany of reasons why a company may request a loan or how the terms of the arrangement may look, this is its basic form.
If the company has already issued the bonds and you are simply buying them after-the-fact whether directly or in a mutual fund (or other structure), you may be paying a premium for that bond, especially in today’s market. You may pay $104 per bond instrument, to get paid $100 at the end of the term…well, why would you even consider doing that? Here are a few reasons why it may make sense:
- 1) You get interest along the way. For simplification, say you purchase bonds at $104, yet they will pay you $5 of interest each year, plus pay you $100 at the end of the term. So continuing our example with a two year bond, you would get $10 in total interest and lose $4 in value, thus netting a total return of $6.
2) With a bond, you (in most instances) have higher claim to the assets of the company if the company goes belly-up than you do with stocks. For instance, if the company goes bankrupt and has to sell their buildings, assets, etc., yet there are bonds and stock outstanding, then the bonds get paid first when the assets are sold. Let’s look at a quick example:
- If a company has bond obligations of $4 billion and stock of $6 billion, yet they only have assets to sell totaling $5 billion, then the bondholders may be able to get all of their investment back, yet the stockholders may be able to get $1 billion (i.e. a $5 billion dollar loss for stockholders – an 83% loss!). It’s no wonder a stock can drop so much on bad news – especially if a company may be at or near bankruptcy and have to sell its assets off.
3) There is a contractual agreement with the company on what they are required to pay you at the end of the term as well as interest along the way.
Unlike a bond, a stock price is predominantly tied to the future earnings of a company. You can sometimes get a dividend (i.e. income) from the company today, but, generally speaking, your hope is that the price of the stock rises. Well, what factors cause a company’s stock price to rise? Let’s start with a few scenarios where a company’s stock may rise:
- 1) Increased growth of the company beyond what is expected today,
2) Expansion of a company’s margin and/or profitability, and/or
3) Rise in future earnings through acquisitions or profitable projects.
If anyone had a crystal ball, then this would be easy! The reality is that it can be extremely difficult to project a company’s future earnings (even with large companies with long-term track records), especially when looking at things through a lens of a multi-year time-horizon. However, over time, stock markets have tended to perform better than bonds, but the performance of the stocks has been much more volatile along the way. Check out the visual below from JP Morgan that shows the performance of bonds versus stocks over long periods of time. The chart shows the range of outcomes -meaning, for a rolling period of time, what the potential return outcomes were – of a bond, stock, or diversified strategy. The shorter the time-period, the wider the range of potential outcomes:
Especially with a company’s earnings being predominantly tied to future earnings AND you have a lower claim on a company’s assets if things go south, it’s no wonder stock values fluctuate like they do.
But, given a long time horizon, shouldn’t you dedicate more of your savings to stocks? Well, the answer isn’t always that clear – especially coming out of the 2001-2002 Tech bubble bursting and the 2008-2009 stock market decline. An important consideration is how comfortable you are to withstand market value fluctuations. In fact, with the 2007-2009 stock market decline, the S&P 500 (the largest 500 publicly traded companies in the US) from the highs to the lows saw their prices decline ON AVERAGE 57%. That means that if you had a $1 million portfolio of 100% in large company US stocks, you could have seen the value decline to below $430,000! Talk about YEARS and YEARS of erased savings! If you had stuck with that same strategy for the next five years, you would have come out back above the $1 million level, but how would you have been able to sleep at night? Would you have been able to just assume “it will all be alright” and hope for the best? Chances are the answer is “not likely.” That’s why it can be important to have a mix of both bonds and stocks in a portfolio to help provide some long-term stability because you never know when you may need some cash from your savings to help with your living expenses or retirement income needs.
While the above is a bit of a simplification of a bond vs. a stock, you get the point. Stocks can be more volatile – though as the bond market has seen lately, it isn’t an absolute – and it doesn’t mean an investor can’t lose money on a bond investment though either – especially when looking at a short time horizon. However, with a bond, you can get that contractual obligation of what the company is required to pay in interest as well as the value they must pay back at the end of the term that doesn’t exist for stocks. So even if prices decline today, you have an idea of what you will ultimately get paid when the bonds reach maturity.
- What do you know about stocks and bonds?
How do you like to invest your money?
Tell us about your experience with investing.
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