Stocks vs. Bonds: Back to #Basics

By Megan Kowalski on July 6, 2021

For those interested in dabbling in the investment world or looking for a refresher, I thought it prudent to go back to basics and begin with two of the most common asset classes: stocks and bonds. Many investment concepts build on each other making it imperative to understand the basics before digging deeper.

Stocks represent direct ownership in a company. Each unit of ownership is known as a share and you become a shareholder when you purchase stock. As a shareholder, you benefit when the company performs well and its stock price rises. Alternatively, if the company underperforms, the stock price can be negatively impacted.

Bonds are issued by a company to raise capital. In exchange for a bond, investors lend the company money for a set duration and receive periodic interest throughout the term. Bonds have specific dollar denominations, known as par value, and are typically $1,000.00. They also have explicitly outlined terms found in their bond indenture (contract) that the borrowing company must adhere to. At the end of the period, or when the bond matures or is called, the company pays the investor back their original loan amount plus the final interest payment.

Let’s work this through with an example…

Investor: Josephine has $1,000 to invest. She would like to understand how her investments would be impacted in different market cycles over the next 5 years if she invests in stocks or bonds.

Total profit/loss after a 5-year period when the position is realized

As you can see, the bond performance is fixed, whereas the stock performance is more market-dependent.

What is driving the risk behind each asset class?

Stocks are inherently riskier than bonds because the stockholders are last in line to be compensated by the company if it were to file bankruptcy or go out of business. To better understand this concept, let’s review the illustration below.

This visual highlights the order in which capital is paid out first during a restructure or bankruptcy proceeding. Although we have not covered the various types of stocks and bonds, you can see that debt is paid out first to the bondholders before the equity holders (stocks) receive anything, making bonds less risky comparatively.

Anything else to consider before taking the plunge?

Taxes are another factor to assess before getting started. Stocks are taxed based on capital gains which are trigger when you realize (sell) the position. In some instances, they may pay a dividend in which case it will be taxed as income each time it is received. Although bonds are meant to mature at their par value, they trade in the secondary market similar to stocks. For that reason, bonds may also have a capital gain or loss realized prior to maturity. Additionally, they are often structured with an interest payment taxed as ordinary income each time it is received.

When comparing stocks versus bonds, there is no superior investment option; it all depends on what is best for you based on your investment time horizon, risk tolerance, and outlined investment goals.

I hope that today’s blog has helped sharpe-n your knowledge of the investment landscape. If you have any topic suggestions or have further questions, please reach out to mkowalski@hightoweradvisors.com.