Bonds vs Stocks: What's the Difference?
Stocks, also called shares, provide ownership in a company, whilst, by buying bonds, investors take on the role of a lender. That distinction, ownership versus lending, largely dictates how bonds and stocks work, how returns are generated and what happens to your investment if the issuer runs into problems.
In this guide, we break down bonds vs stocks in detail: where the two overlap, how each can suit different goals, and how to invest in both.
The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.
Key Takeaways
- Stocks provide ownership in a company, whereas bonds make you a lender to a company or government.
- Stocks generate potential returns through share price gains and dividends; bonds pay interest, known as a coupon, and can also be sold for a gain or loss before maturity.
- Bonds tend to carry lower risk and lower potential returns than stocks, though neither is risk-free.
- If a company is liquidated, bondholders are repaid before shareholders.
- Portfolios often hold a mixture of both. The exact balance of this mixture can depend on time horizon and income needs, amongst other considerations.
Table of Contents
What Are Stocks and Bonds?
In simple terms, a stock provides ownership of a company, whilst a bond makes you a lender to one.
- Stocks (Shares): A unit of ownership in a company; bought and sold on a stock exchange.
- Bonds: A loan to a company or government, repaid with interest over a set term.
What Are Stocks?
When a company wants to raise money, it can sell shares to investors, with each share representing a unit of ownership in the company. "Equity" and "equities" are the collective terms often used for stocks as an asset class, so you'll often see these words used interchangeably.
As a shareholder, the performance of your investment is tied to the company's. If it grows, the value of your shares tends to rise with it; on the other hand, if it struggles, share price usually falls.
Many shares also come with voting rights, giving shareholders a say on how the company is run.
There's no fixed end date to holding a share and no guaranteed payout. You can typically hold onto them for as long as you choose, and your ultimate return will mostly depend on the price someone else is willing to pay for it when you come to sell.
What Are Bonds?
When you buy a bond, you're essentially lending money to the issuing entity, rather than buying a stake in it.
In exchange, the issuer agrees to pay you interest at set intervals and to return your original investment, known as the principal or face value, on a fixed date: the maturity date.
The interest paid on a bond is called the coupon, and it's often fixed from the beginning, which is where the term "fixed income" comes from. Consequently, the amount you’re due to be paid, and when, is determined from the start, provided the issuer meets its obligations.
That last point is important. A bond is a debt instrument, and there is always the risk that it won't be repaid, known as the risk of default. Bonds are generally considered less risky than stocks, but they're not risk free. The exact level of risk depends largely on the issuing entity.
Bonds vs Stocks: Key Differences
The table below sets out some of the main differences between stocks and bonds.
The Difference Between Stocks and Bonds Explained
In the following sections, we’ll examine the differences between stocks and bonds in more detail.
Ownership vs Lending
Buying a stock makes you a part-owner of a company; each share represents an equity stake in the business. On the other hand, buying a bond essentially makes you a lender. Your money is debt owed by the company or government that issued the bond, and your relationship with the issuer is contractual.
That distinction is why stocks are sometimes called equity investments and bonds are called debt or fixed income investments.
A shareholder benefits, or loses, from the company's performance directly. A bondholder is owed a specific sum on specific terms, regardless of how the issuer's underlying business performs.
Dividends vs Coupons
Stocks and bonds can both generate potential income for your portfolio. However, the way in which that income works is different.
With stocks, potential income comes in the form of dividends. This is a voluntary payment which a company can choose to make to shareholders from its earnings. Not all companies pay them and, for those that do, payouts can be cut or suspended at any time.
A bond’s income comes from the coupon, an interest payment which is set when the bond is initially issued. Coupons are paid at regular intervals, typically every six or twelve months, until the bond matures. This gives coupons an element of predictability which doesn’t exist with dividends.
Except in the case of default, the performance of the issuer does not affect the value of the coupon. However, certain bonds are inflation-linked, meaning their coupons periodically adjust in line with an official inflation index.
One slight exception here is preferred shares, which typically pay a fixed dividend rate and are prioritised ahead of ordinary shareholders. That makes preferred dividends closer to a bond's coupon than an ordinary share's variable and discretionary payout. However, a preferred dividend can still be suspended if a company runs into real difficulty.
Risk
Although stocks offer higher potential returns than bonds, they come with higher risk. Share prices can move sharply in both directions, sometimes unpredictably, in response to company-specific factors or broader market sentiment.
Bonds are generally considered to be less risky, and their prices also tend to be steadier. Nevertheless, although bonds are often categorised as lower risk, it’s important to remember that they do still carry risk. The three main risks to be aware of when investing in bonds are:
- Default: The risk that the issuing entity defaults on its debt and is not able to repay bondholders. The exact level of risk depends on the issuing entity.
- Inflation: Over time, fixed coupons can be eroded in real terms by inflation. Whilst some bonds are inflation-linked, the majority are not.
- Interest Rates: Bond prices and interest rates have an inverse relationship, meaning that when interest rates rise, bond prices fall, and vice versa. This mainly matters if a bond is sold on the secondary market before maturity: a price fall could mean selling at a loss, whilst a price rise could mean selling at a gain.
Priority If a Company Fails
If a company enters bankruptcy and its assets are liquidated, there is a repayment hierarchy for how funds get distributed.
As creditors, bondholders rank ahead of shareholders, who sit at the bottom of the hierarchy. In other words, when a company enters liquidation, bondholders are repaid before shareholders. If there’s nothing left once bondholders and other creditors are repaid, shareholders receive nothing.
Voting Rights
Many, but not all, shares come with voting rights, giving shareholders a say on how the company is run. The more shares an investor holds, the more voting power they typically carry. On the other hand, bondholders have no ownership stake and, consequently, no vote.
Maturity Dates
A bond has a fixed lifespan. It's issued with a maturity date, the point at which the issuer repays the principal in full, with coupon payments made in the interim. Maturities vary depending on the bond, ranging from a matter of months to several decades.
On the other hand, a share can be held for as long as the company exists as a public entity and the investor chooses to hold it.
Liquidity
Shares are typically bought and sold on centralised stock exchanges, where prices are continuously quoted throughout the trading day. For widely held stocks, liquidity tends to be high, meaning that they’re quick and easy to buy and sell. It also results in typically narrower spreads.
Bonds mostly trade over the counter (OTC) rather than on a centralised exchange, meaning that deals are arranged directly between parties. This generally results in lower liquidity, meaning spreads can be wider and some bonds can be slower to buy and sell than shares.
What Bonds and Shares Have in Common
Despite the differences covered above, stocks and bonds also have certain similarities:
- Both can be bought and sold through a broker.
- Both carry a degree of risk.
- Both have historically had the potential to outpace cash savings over time.
- Both can form part of the same diversified investment portfolio.
Bonds vs Stocks: Which Is Better for Your Portfolio?
There's no universal answer as to whether stocks or bonds are better, as each has its own characteristics that appeal to different types of investors. Indeed, both can play different roles in the same portfolio.
Time Horizon
How long money is likely to stay invested is one of the most common considerations when weighing stocks against bonds.
A longer time horizon gives stocks more time to recover from periods of volatility, whilst a shorter time horizon leaves less room to ride out a downturn before the money is needed.
This is the thinking behind approaches to investing where portfolios are weighted more heavily towards stocks earlier on and gradually shifted towards bonds as a target date, such as retirement, approaches.
Income Needs
Investors looking for a predictable income stream often find bonds more straightforward than stocks, since a bond's coupon is fixed and scheduled from the outset.
Dividend-paying stocks can also generate income, but dividends are discretionary and can be reduced or stopped, which makes them less predictable than a bond's coupon.
However, investors who are more interested in growing their capital over time may place greater emphasis on stocks for their return potential, accepting the added volatility that comes with them.
Risk Tolerance
The level of risk which an investor is comfortable with is another deciding factor in the choice between stocks and bonds.
Stocks have historically offered higher long-term returns than bonds, but with greater price swings along the way. Bonds have historically offered more predictable, lower returns with less volatility, though not none.
How to Invest in Stocks and Bonds
There are several routes to gaining exposure to stocks and bonds, although availability of specific instruments will vary depending on the broker in question:
- Buying shares directly: purchasing individual company stocks, giving direct ownership and control over which businesses are held.
- Stock funds and ETFs: exposure to a basket of shares via a fund or exchange-traded fund (ETF), often tracking a stock index.
- Buying bonds directly: purchasing individual government or corporate bonds through a broker, typically on the secondary market.
- Bond funds and ETFs: exposure to a basket of bonds across issuers and maturities, bought and sold as a single unit.
There's an important difference between buying a bond directly and investing in a bond fund or ETF.
An individual bond has its own maturity date and, barring default, the principal is returned to the bondholder when that date arrives. However, as a bond fund or ETF holds many bonds at the same time, it doesn't work to a single maturity date. Its value can keep moving up or down as interest rates and the underlying bonds it holds change.
Steps to Start Investing in Stocks and Bonds
- Open an investment account. This is the starting point for all of the routes above. Availability of specific instruments, such as individual bonds, vary depending on broker, so it’s worth checking what’s available before registering for an account.
- Decide on an allocation between stocks and bonds. How much goes to each tends to follow from time horizon, income needs and risk tolerance.
- Choose a route for each. Individual shares or bonds provide more control, whereas funds and ETFs offer broad diversification, with less ongoing selection required.
- Research and select specific holdings. This might mean individual companies and bond issuers, or specific funds and ETFs that match the chosen allocation.
- Place the order. Buy orders can typically be placed through an account's trading platform.
- Monitor and review the portfolio over time. Allocations can drift as stocks and bonds perform differently, so investors may choose to periodically rebalance back towards their intended split.
With Admirals, you can access thousands of stocks and a range of ETFs, including selected bond ETFs. Individual government and corporate bonds are not currently available.
Frequently Asked Questions
Are bonds safer than stocks?
Bonds are generally considered lower risk than stocks. Their prices tend to be less volatile, and bondholders are repaid before shareholders if a company is liquidated. However, bonds are not risk-free: the issuing entity can default on its debt, inflation can erode a bond’s real returns and rising interest rates typically depress bond prices.
Can I invest in bonds with Admirals?
Whilst Admirals does not currently offer individual government or corporate bonds, clients can gain exposure to the bond market through selected bond ETFs.
Why do bond prices fall when interest rates rise?
Existing bonds pay a fixed coupon which is set when the bond is issued. When interest rates rise, newly issued bonds offer higher coupons, making older, lower-coupon bonds less attractive by comparison. Consequently, their market price falls, which pushes up the yield (the income they pay relative to their current price), bringing it back in line with prevailing rates.
What is the difference between a bond and a share?
A share represents ownership in a company; its value depends on how the company performs and there is no guaranteed payout. A bond is a debt instrument, which represents a loan to a company or government. It pays a fixed coupon and returns the principal at a set maturity date, regardless of how the issuer performs in the meantime, barring default.
Do bonds and stocks always move in opposite directions?
Not always. Stocks and bonds are often described as having an inverse relationship, since investors sometimes shift towards bonds when stock prices fall, and vice versa. Whilst this has often been the case, there have also been periods, such as during high inflation, where both fall together, since both can be sensitive to rising interest rates.
What are the alternatives to stocks and bonds?
Stocks and bonds are the two most common parts of an investment portfolio, but they aren’t the only options. Alternatives sometimes considered alongside or instead of them include property, commodities such as gold, and cash or cash equivalents, each with its own risk and return profile.
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