Bonds vs Stocks: What Is the Difference Between Stocks and Bonds?
When considering investment opportunities, stocks and bonds are usually the first to jump into peoples’ minds. Although both are used to generate a return, the way in which they accomplish this is very different.
In this article, we will help you gain a better understanding of the two types of investment, highlight the differences of bonds vs stocks and establish which might be the more appropriate investment for you.
Buying stocks is akin to buying a portion, or share, of a company, meaning that, as a shareholder, you are essentially a part-owner of that company.
Therefore, when it comes to stocks, the success and return of your investment is dependent on the success of the company. The better the company does, the better your investment does. Of course, the opposite is also true.
Bonds are what is known as a “fixed-income” instrument. When you buy a bond, you are lending money to the issuing entity – whether a corporation or government - which they simultaneously undertake to repay you on a fixed date in the future, together with any applicable interest in the interim.
Straight away, a key difference between stocks and bonds should be apparent – namely that, with a bond – the repayment amount is fixed from the outset and the future success of the bond-issuer will not impact this figure.
However, that does not mean that bonds are without risk, something we will look at more closely later.
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Bonds vs Stocks: The Main Differences
Now we have fairly basic definitions of stocks and bonds, what are their differences and which is more suitable for you?
Income vs Capital Gains
Whilst the purpose of both investments may be the similar – to generate returns – stocks and bonds achieve this in very different ways; one via regular, fixed income and the other mainly by capital gains.
Bonds generate income for investors by way of interest payments, known as coupon payments, which are fixed at the beginning of the bond’s term. These coupon payments are made regularly until the bond’s maturity; how regularly depends on the bond in question. Once the bond has matured, the full amount the bond was originally sold for, the principal, is returned to the investor.
Many stocks also make regular payments to shareholders in the form of dividends. Unlike coupons, these payments vary from one period to another and may not be paid at all. Generally, young, fast-growing companies tend not to pay dividends (or to pay smaller ones), whereas larger, more mature companies do – providing they make a profit.
In order for an investor to profit from stocks, they need to sell their shares for a higher price than what they originally paid for them, or to collect dividends. This means that - unlike bonds, which have a fixed rate of return baked into them – stock market investors do not know beforehand exactly how much money their investment will generate for them, if it generates anything at all.
With bonds, there is a predetermined limit to how much your original investment will generate. With stocks, there is, in theory, no limit to your potential returns.
Debt vs Equity
When you buy a bond, you are lending money to a corporation or government, which must be repaid together with any predetermined interest.
In this way, a bond can be thought of like an ‘IOU’ between the investor and the bond-issuer. Bondholders have no influence over the borrowing entity or any stake in their business - they are simply a lender who must be repaid.
This is another key area where stocks and bonds differ. Buying shares in a company buys you equity in the company; as a shareholder, you are a part-owner. This means that - as well as sharing in the future success, or failure, of the company – you also usually receive voting rights, enabling you to have your say on how the company is run.
In the first difference between stocks and bonds, we said that whilst bonds have a fixed rate of return, stocks have no limit to how much they can potentially return.
However, it is important for anyone considering bonds vs stocks as an investment to understand that the risk profiles of the two are very different. With their higher potential return, stocks also tend to have higher associated risk.
The risk associated with investing in stocks is that, after you have purchased them, the share price falls. The main reason for this happening would be if a company underperforms, but it could also be caused by a variety of other unrelated factors.
For example, if a company’s reputation is tarnished by a scandal, it operates in an industry which has become unpopular or they have been the victim of new regulations which hamper their business.
Although bonds are typically seen as the “safer” investment between the two, it is important to remember that they are not without risk. Bonds carry the risk of default, in other words, the risk that the bond issuer does not pay you back the agreed upon interest or the principal.
A bond’s level of risk really depends on the bond issuer. At one end of the spectrum, you will find investment grade bonds; bonds which are issued by entities with a high credit rating and are, therefore, deemed low risk. However, these bonds will also have a low interest rate.
At the other end of the spectrum, you have junk bonds; these bonds will have higher returns, but they are issued by entities with low credit ratings and, therefore, carry a higher level of risk.
However, when weighing up the risk and reward of bonds vs stocks, it is also worth considering that if a company goes into liquidation, its bondholders will be prioritised over shareholders when distributing any remaining funds.
Stocks or Bonds? Or Stocks AND Bonds?
So, which is better? There is no real answer to this question mainly because, as we have seen, stocks and bonds are two very different instruments which can be used to achieve different goals.
Bonds are potentially more suitable for income investors, whereas stocks are more suitable for investors targeting growth.
However, it is not necessarily a question of stocks or bonds. The majority of successful investors will tell you that a healthy portfolio is made up of holdings in stocks and bonds. Investing in different asset classes provides an investor with diversification, which is an integral part of risk management.
If you are interested in learning more about stocks and bonds, you might be interested in reading the following articles:
How to Invest in Stocks and Bonds With Admirals
With an Invest.MT5 account from Admirals, you can invest in over 4,300 shares from 15 of the world’s largest stock exchanges!
Furthermore, the Invest.MT5 account also allows you to invest in a variety of bond ETFs (Exchange-Traded Funds). Bond ETFs pool investor money in order to invest exclusively in bonds, meaning that with one investment, you can gain exposure to a range of bonds.
In order to invest in stocks and bonds with Admirals, follow these steps:
1. Register for an Invest.MT5 account
2. Download and open the MetaTrader 5 trading platform
3. Press Control + U to bring up the Symbols window, shown below. From here, you can search for stocks or bond ETFs. Once you have found what you are looking for, press ‘Show Symbol’ and ‘OK’.
4. Locate the symbol in ‘Market Watch’ on the left-hand side of the screen, right-click on it and click ‘Chart Window’ to open a price chart.
5. Select ‘New Order’ from the top of the screen to bring up an order window. Fill out how many shares you want to buy together with a stop loss and take profit if desired. Then click ‘Buy’ to send your order to the market.
Why Invest With Admirals?
Besides being able to invest in over 4,300 stocks and over 300 ETFs from 15 of the largest stock exchanges in the world, Invest.MT5 account holders also benefit from:
- The ability to open an account with a minimum deposit of just €1
- Low commissions and no account maintenance fee
- Free use of the world’s number one multi-asset trading platform, MetaTrader 5
- Exclusive access to our Premium Analytics portal, where you will find the latest market news, sentiment and technical insight
- Regular fundamental and technical analysis, as well access to a wide range of educational articles at no additional cost!
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.