Stocks vs Bonds: Portfolio Investments

Posted By: Advisor Analyzer Team

Stocks and bonds: the two cornerstones of corporate America’s capital structure and the foundation for any modern investor’s portfolio. While both are bought and sold more frequently than a used Toyota, the two approaches to raising corporate capital are in fact, quite different.  

Growth vs. Stability

Stocks represent ownership: an equity stake in a company. The returns are based on corporate profits, dividends and future growth prospects. As the profits increase the stock price appreciates to reflect the increase in retained earnings to shareholder’s equity on the balance sheet. Dividends are paid from a portion of earnings as a return on investment to shareholders.  

 

Although paid relatively consistently, dividends are not an obligation of the company, and can be discontinued at any time. If the company experiences a period of weak earnings or need the funds for growth, dividends are usually the first to be cut. Therefore, dividends do not have a set payment schedule and equities have no pre-established maturity value.  

 

Investors of equities are usually at the bottom of the totem pole when a company experiences bankruptcy. They have the right to the residual proceeds from liquidation after all debt holders are paid. Due to the increased risk, equities investors have the highest expected return potential. If a company experiences significant growth in earnings, shareholders have a proportional interest in assets after all liabilities have been satisfied. Therefore, equity investors seek significant earnings growth and are willing to take major risks in achieving them.    

 

On the other hand, bonds represent an obligation of the company. It is a promise of coupon payments and the return of principal to its debt holders at maturity. The rate at which a firm borrows depends on the market interest rate, the term of the loan, the firms overall capital structure, earnings stability and credit rating, to name a few. A company’s Debtors rank higher in the corporate hierarchy to equity holders, and have a seniority claim to funds from liquidation in the event of bankruptcy.

However, in exchange for the senior status, bondholders have an asymmetric expected return profile. Bond investors do not share a proportional claim on profits, so the expected returns are limited to the promised payments regardless of the company’s earnings success. However, the potential loss to a bondholder can be the whole principal amount in the event of bankruptcy. Since there’s no benefit to a high risk high return ventures, bond investors prefer a company avoid risk taking activities and generate stable and predictable cash flows to satisfy the interest payments promised.     

Liquidity and Markets

Stocks are usually bought and sold on an exchange. They generally trade more frequently than bonds, and thus have a lower liquidity premium, when measured by the bid ask spread. If an investors would like to purchase a stock, they can buy at the market ask price, which is the lowest price someone will sell. Likewise, to sell their equity position, investors enter the open market and sell at the highest bid price. The highest bid price and lowest ask price comprise the bid ask spread. Generally, as the number of market participants trading the position increase, the bid ask spread decreases. Therefore, the bid ask spread is a common way to gauge the liquidity of an equity investment.  

 

While the bond markets are substantially larger than the stock markets, bonds do not trade on the same platform or with the same frequency. Bonds, unlike stocks, are not traded on an exchange but over-the-counter. Over the counter markets usually have dealers who make markets and investors call a bank holding the desired bond to obtain a quote.  Bond investors usually hold positions for longer periods so bonds do not trade as often as stocks. The result is less transparent pricing as compared to equities, and larger premiums embedded in the bond’s cost. To more accurately reflect a bond’s value, banks usually have sophisticated models that determine price as a function of interest rates, term to maturity, bond’s yield, and credit spreads, to name a few.  

Conclusion

To conclude, bonds and stocks are vastly different instruments. One represents ownership, while the other is purely a loan to the company. The expected return profiles contrast sharply, in that equity investors seek significant growth in earnings, while bond investors prefer stability. The mechanics behind how they are priced and traded vary depending on the market structure, and there can be significant costs due to illiquidity. While stocks are bonds share the spotlight in making corporate America what it is today, their roles in its formation are unique and different.