Have you ever wondered why or when you should look at bonds vs looking at equities? What’s the real difference between them anyway?
Written by our Risk Manager in London, today’s article dives into the important bit for you as an investor – what do you need to know when you’re thinking about investing in bonds vs equities.
Let’s get into it below!
This article is a 8 minute read.
As an investor, if you want to invest in a company then you have a choice to make.
You can either invest in the company’s shares or – if it has issued any – you can invest in its bonds.
Both equity and bonds are financial instruments that companies use to raise the funds needed to finance their operations. Usually, those operations are funded via a mixture of equity and bonds (often referred to as debt).
If you choose to buy shares in a target company, you are planning to make an equity investment and you become part owner of the company. If you choose to buy bonds you become a lender to the company.
Depending on your investment choice, the rights you hold, the multitude of the return you receive, and the risk exposure you face will differ.
As we have already stated, if you buy shares, you become part owner of the company.
If your shareholding is of sufficient size, you may be able to influence the strategic direction of the company – witness Elon Musk’s takeover of Twitter.
Ownership of shares has a significant upside and an equally noticeable downside. If the company, you have invested in is quoted on a stock exchange the share price will rise and fall according to market forces. If the share price rises, then you can sell the share to realise a profit. If you retain the shares the company may declare a dividend (although this is not a guaranteed right) providing you with an income stream.
The downside of owning shares is that the market price could fall significantly meaning that the amount you initially invested is at risk. If the company falls into liquidation, shareholders are the last in line to be repaid, if they are repaid at all.
Those that invest in bonds are in a more secure position, especially if the company falls into liquidation as bond holders are repaid in preference (before shareholders). Investors in bonds are paid regular coupon payments. The coupon payments are fixed in amount and timing.
The risk profile of equity investments is higher than that of bonds because swings in the value of equity investments quoted on stock exchanges tend to be more severe.
There are caveats to this.
First, there are categories of bonds issued by high-risk companies and countries and the value of those types of bonds can be as volatile as equity investments. These categories of bonds are often referred to as high-yield and referenced by the moniker “junk.”
Secondly, bonds issued in this category often come with a higher risk of default meaning that the amount you invest in the bond is also at risk.
Some bonds issued by governments to finance their development plans are also considered to be high-risk. This is often true of bonds issued by developing countries. These developing countries are often referred to as emerging markets.
Irrespective of your investment choice – equity or bond – all investment types are effectively rated for risk either by rating agencies or the market itself. The riskier an investment is perceived to be, the higher the potential to make a gain, but the converse is also true. There is also a higher risk that you will make a loss.
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A judicious mixture of equity and bond investments can often be crafted into a balanced and diversified portfolio that will place the investor in a position to weather minor economic shocks. A balanced portfolio of the two types will provide the investor with different benefits.
Bonds will provide a regular flow of income in the form of coupon payments while equities offer the potential for capital growth as the price of shares rises on the stock exchange.
EQUITY (Shares) DEBT (Bonds) Investment Part Owner. Lender to the company. Income Stream Dividend Income Stream paid at discretion of the company. Level of dividend income is often dependent on the company’s performance. Regular coupon payments. The amount and timing of the payments is fixed and certain unless the company defaults. Capital Preservation Depends upon the share price when the equity investment is sold. The amount invested in the bond is repaid in full at the date of maturity provided the company does not default. Risk Profile Higher. Lower. Company Performs Well Dividend payments may increase, and the share price may also rise. Coupon payments remain at the same level. The principal received at maturity does not change. Company Performs Poorly Dividend payments may decrease or stop altogether. The shareholder may lose some or all the capital invested as the share price will potentially fall. Coupon payments remain at the same level. The principal received at maturity does not change provided the company does not default. Company Enters Bankruptcy Shares become worthless. Potential to lose some or all the capital invested. Bondholders have a higher claim on remaining assets than equity owners. Potential to lose some or all the capital invested depending on financial situation of the company.
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