If you have ever had the chance to listen to the investment gurus, chances are that you have heard them comparing and contrasting bonds and stocks. These two investment vehicles may seem closely related but in reality, they are as different as night and day. So, are bonds safer than stocks? Let’s break this down further for you.
Bonds or Stocks: Which One’s Safer?
Quick Summary: Bonds are more stable in the long run and they are always repaid first in case of bankruptcy. However, with the right analysis, stocks stand to provide better returns and can hedge inflation better than bonds.
On the surface, though, bonds may seem safer, but if you analyze things closely, you’ll realize that diversifying your investment in the two is the ultimate key to safety. Read on to find out why.
What Are Bonds?
Bonds are units of debt borrowed from investors either by governments or corporate institutions. That is, whenever these institutions need to raise money for their long-term projects, they do so by selling bonds.
Likewise, as an investor, when you choose this investment vehicle, you are paid back in interest rates (also known as coupons). Some institutions pay their coupons every 6 months while others do so on an annual basis.
Three different types of bonds exist and these are:
Treasury Bonds – Also known as government bonds, these are low-risk investment tools that are usually backed by the government. It is very rare for governments to default on bonds although it does happen from time to time.
Corporate Bonds – This is the second most popular type of debt instrument and as its name suggests, it is normally facilitated by corporate institutions. Such companies sell bonds as they seek to raise funds for long-term investment projects. But unlike government bonds, corporate bonds have a slightly higher risk of default because companies are more likely to go bankrupt than governments.
Municipal Bonds – These are almost similar to government bonds only that they are issued by city, town, or state governments instead of the federal government. Unlike the corporate ones, these are typically tax-free.
What Are Stocks
Stocks need no introduction. When companies need to grow and expand, they typically allow members of the public to purchase units of ownership in them. As members of the public take ownership, the company raises the money it needs to grow.
In other words, while bondholders act as mere financiers, stockholders act as owners. And as you know, when you own a company, you share its risks and rewards.
That is to say, companies whose stocks you own are not obligated to pay your dividends. If they find that the business is not doing well, they have the right to refuse all dividend payments.
However, when you invest in stocks, you need to realize that you’re betting on the future of the company. The idea usually is to find companies that have a promising future, invest in them and then reap the rewards when they grow big.
The Relationship Between Bonds and Stocks
One interesting thing about bonds and stocks is that they tend to move in opposite directions. That is, as the stocks appreciate, the bonds plummet (and vice versa).
Why is this the case? This happens because there’s only so much investment capital available at any given time. Generally, when investors are optimistic about certain companies performing well, they tend to invest in stocks thereby reducing the demand for bonds.
This correlation between demand and supply means that whenever the appetite for bonds is high, demand for bonds reduces and this also sees the gains from bonds reduce.
And of course, vice-versa is true. There are many times when investors prefer to curb their appetite for potentially huge stock returns in favor of the modest returns offered by bonds.
Lastly, there are extremely rare occasions when both bonds and stocks fall. This happens when the investment environment as a whole proves hostile prompting investors to sell off their investments in panic.
Situations When Bonds Are Better Than Stocks
As we have mentioned, bonds are not always perfect. They often perform poorly and are, therefore, not as perfectly safe as some people might want you to believe. That said, the following are the situations when bonds prove safer than stocks.
When The Inflation Rate is Low
Bond yields are usually paid in interest rates (or coupons). This is usually a percentage figure that is communicated to you before you invest.
For instance, the US 10-Year Government Bond has a long-term average of 5.92%. At the same time, the country’s inflation rate stands are 4.7%.
Purchasing bonds in an environment with a high inflation rate is always a bad idea. But when the inflation rate remains considerably low, it is possible to hedge against it and still enjoy some decent bond returns at the end of the day.
When Looking for Predictable Returns
A bond is a contract between you and the government or a corporate institution that they will pay you a certain amount of cash in form of returns. Therefore, it doesn't matter whether they are making profits or losses, they are obligated to send your paycheck within the agreed period.
And in the event of bankruptcy, bondholders are always given the first priority ahead of stockholders.
For this reason, bonds are seen as safer than stocks because stocks don’t come with a commitment that you’ll receive dividends are the end of the year.
In other words, bonds cushion you from the risks of business ownership that come with stocks.
In Situations When You May Need to Borrow Cash for Bonds
This is a major benefit of bond ownership. Should you run short of cash at one point or another, you can always borrow against your bonds. Why so? Because bonds are generally stable and easier to quantify, therefore, making it easier for lenders to work with.
What’s more, unlike stocks, bond prices remain relatively unchanged for many months. Therefore, borrowing against bonds is safer than borrowing against stocks.
If you happen to borrow against stocks and their prices go below the margin maintenance requirement, you'll receive a margin call. That way, unless you deposit more funds, your broker is legally obligated to sell some of your equity and use it to pay down the loan.
In some cases, they’ll do this without contacting you first!
When Stocks Are Doing Poorly
The stock market can be downright unpredictable at times. And while its high volatility often provides some great opportunities to profit (especially for day traders), it also exposes you to a great degree of risk.
Stocks are like double-edged swords. With a good strategy, it is possible to make decent returns – a slight miscalculation, however, is all it takes to be in the red.
In such conditions, bonds can prove safer because, at the very least, they are not as volatile as stocks.
Situations When Bonds Are the Riskier Choice
Bonds are not the proverbial goose that lays golden eggs! In some cases, it can be riskier to invest in bonds.
Inflation is High
Bonds are unsafe to hold when the inflation rate is dramatically high. This is especially the case when investors opt for fixed interest rates.
Let’s take an example – if an investor buys a bond with a fixed rate of return of 3% only for the inflation to grow to 4%, it means the investor’s ROI is actually at -1%. The investor is actually losing out in that case.
When the Risk of Default is High
Corporate bonds are particularly known to have a higher risk of default than government bonds. This is why it is extremely important for investors to scrutinize the creditworthiness of a company prior to putting their money on it.
Please also note that, whenever corporate institutions float bonds, they are not required to back them up with collateral. In other words, bonds are debentures. And if a bond issuer fails to honor their obligation, you could lose all or part of your investment.
Situations When Interest Rates Fall
If you happen to opt for bonds with variable interest rates, you’d effectively expose yourself to the risk of market fluctuations. And should the interest rates fall way below the inflation rate, it goes without saying that you’d be making losses.
That said, variable-rate bonds are a good way to capitalize on rising interest rates from time to time.
The lower the risk, the lower the returns; and the higher the risk, the higher the returns. This is usually the case in the bonds and stocks market.
The stock market has its fair share of risks but the rewards can be a lot higher than those of bonds. Bonds are theoretically considered low-risk but they are not entirely risk-free. A rise in inflation levels and the ever-present risk of default can make the otherwise smooth bond investing journey bumpy even for experienced investors.
So, take your time, do your calculations and make the right move. If you have a medium-to-high risk appetite, an investment in stocks might just be the best move you can ever make. If you're risk-averse, bonds might offer a much safer option (though not entirely risk-free).
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