Stocks versus bonds:
A research study
By Cassandra Tagert
Introduction
This paper will define the properties of stocks and bonds. It will also evaluate the differences, pros, and cons between bonds, stocks, and different types of both. This information will provide insight on why or why not to invest in either stocks or bonds for the individual investor.
Literature Review
In deciding whether or not to invest one’s money into either stocks or bonds, it is important to understand what each of them are and how they work. Bonds are issued by either the government or individual corporations in order to make money quickly. The bond holder pays the issuer the face value of the bond, and in return, the issuer pays the holder a specific amount of interest each year. At the end of a designated time period, the bond issuer repays the face value of the bond. Also, depending on the length of the bond, usually the longer maturity bonds, they are sensitive to interest rate variations. Many individuals prefer to invest in bonds because there is less risk as the issuer is legally obligated to pay them back. In addition to this, government bonds are considered almost risk free because they are backed by the United States Treasury. (Yang, 4)
Stocks are issued by companies, and each stock is, essentially, a piece of that company. Stockholders can hold their stocks for an indefinite amount of time in order to collect dividend revenue or sell the shares to make a profit. Many individuals decide to invest in stock because they have a greater ability to make money through stocks as the individual stocks gain value. However, there is more risk in investing in stocks because the stocks could lose value as well.
So knowing all of this information, the next step in deciding whether to invest more in stocks or bonds is recognize the purpose of doing so. For example, if one is investing solely for the purpose of trying to create a steady income, they should invest in bonds. Investing in bonds is more reliable because there is the company’s guarantee to pay them off eventually, and bonds are protected from inflation. In the event that a company folds, they might not be able to pay the bond holder back. In which case, the bond holder can sue because the bond holder and the company sign a legal document called an indenture that requires the company to pay it back. Although, some bonds have call provision, which allows the bond issuer to call the bond back at a certain price if interest rates go down and replace the bond with a more manageable debt. This is one of the few risks associated with bonds. Though, gains from bonds are a lot lower than from stocks because bonds have lower interest rates, and they often lose value over the years. (Lutts, 1)
There are different types of bonds to consider when deciding to invest. Corporate bonds are bonds that are issued by a company rather than the federal government. There are two different types of corporate bonds. One type is a secured corporate bond, which is backed by collateral is the company can’t pay back the bond. The other type is an unsecured corporate bond or “debenture.” Debentures are more risky because the company may not have to pay you back if they can’t. Besides corporate bonds, there are treasury and agency bonds. These bonds are risk free since they are backed by the government, but the downside is that they have the lowest interest rates. The interest payments that come from these bonds are also exempt from state and local taxes. There are also municipal bonds, which are issued by states, cities, or counties. These bonds are also tax exempt. The last type of bonds don’t fall into a category. There are zero coupon bonds, which don’t pay interest, and there are junk bonds. Junk bonds are high-yielding, but they are very risky as they are usually issued by firms that don’t have a good performance record. It’s important to evaluate which type of bond works the best for the individual investor.
One thing that is important to keep in mind about bonds is how they are rated. Bonds are rated with letters. The safest bonds are rated AAA, and the least safe bonds receive a D. The ratings signify a bond’s potential future risk, so for example, a bond rated with a D is likely to default. Although, bonds with poorer rating also have higher potential rate of return.
The length of a bond is an important factor to keep in mind as well. Longer-term bonds fluctuate in price more than shorter-term bonds. If interest rates are expected to rise, then short term bonds are the best idea because they are more interest resistant. If interest rates aren’t expected to rise, longer-term bonds are better because they have longer maturities and aren’t callable. So, while there is less risk with bonds, they aren’t necessarily totally risk free (unless they are federal bonds). They also have less chance for capital gain.
However, if one wants to make a large amount of money, the stock market is better to invest in. The value of any individual stock has the opportunity to increase greatly. This way investors can gain money in addition to the dividend income that is possible to receive from the issuing company. Even though there is a possibility to gain a lot of money this way, it is also possible to lose a lot of money this way if the stock decreases in value. So, because there is more risk with the stock market, it is not a good way to create a steady income, but it is a good way to increase profits if one is less risk-averse.
In addition to this, there are different types of stocks to take into account. There are common stocks and preferred stocks. Common stocks are partial ownership of a company. People with a certain amount of common shares (which is designated by the company), are entitled to voting rights within the company. These shares allow shareholders to elect a board of directors who represent them in company matters. Some downsides to having common stock are that neither receiving dividends nor capital appreciation is guaranteed. The biggest downside to owning common stock is that these stockholders are the last in line to receive company assets in the event of a company closing its doors. These stockholders receive dividend payments, but only after preferred stockholders have already received theirs. (Investor Guide, 2) In addition to this, common stocks are greatly affected by interest rates, which makes them riskier. If interest rates rise, the present value of future dividends declines. Although with more risk comes more opportunity for capital gain.
There are many different types of common stocks as well. Blue chip stocks are issued by large companies that are known to have sturdy financial histories such as IBM. Growth stocks are issued by companies that are generally smaller and newer; these companies have sales and earnings growth above the average. An example of a growth stock is Microsoft. Income stocks come from “mature firms” that pay high dividends, but there is little chance of an increase in earnings. Speculative stocks are stocks that are a lot riskier because they are a lot more variable. Cyclical stocks tend to follow the flow of the economy; if the economy takes a downturn, so do these stocks. Defensive stocks are stocks that aren’t affected as much by the flow of the economy; in fact, some of these stocks, such as Dollar Tree, do better in economic downturns. In order to properly decide if one wants to invest in common stocks, it is important to assess all types and which is the best fit for the individual investor.
On top of all of the different type of common stock, one way common stock is assessed is by its “cap.” The “cap” is a term, which refers to the size of the firm and its market value. Large cap stocks are valued above 5 billion dollars. Mid-cap stocks are valued between 1 billion dollars and 5 billion dollars. Small cap stocks are valued below 1 billion dollars. Another way common stocks are assessed is by how responsive that particular stock is to changes in the market. This is called “beta.” The market’s beta is 1. So, if a stock has a beta greater than one then it is more variable market. If the stock has a beta that is less than one then it is less variable than the market. It is important to be aware of a stocks’ cap size and variability because it shows how variable and how strong they are.
Preferred stock, on the other hand, is partial ownership of a company without the same voting rights. Preferred stockholders receive a fixed dividend, but the company may not pay it if they do not have the ability to do so. Preferred stockholders receive assets before common stockholders. Preferred stock fluctuate less in price than common shares, which means the opportunity for large monetary gains is still there but with less ability to lose as much. They are callable, and their dividends are fixed. Preferred stock can also have an adjustable rate, which allows the quarterly dividends to fluctuate with the market interest rate. They can be convertible as well. This allows an investor to trade in their preferred stocks for a certain amount of common stocks.
So with this in mind, preferred stocks and bonds can seem quite similar if one is not familiar with their differences. While preferred stocks and bonds both receive their benefits before common stocks do and neither have voting rights, there are many differences between the two. Bonds take precedence over preferred stocks, so bond holders receive benefits before preferred stock holders. There is more risk with preferred stocks because there is a greater ability for them to lose value, but they also typically have a higher yield than bonds. Preferred stocks (like common stocks) also don’t have a fixed maturity date, which bonds always have. (Investopedia, 3)
Conclusion
The decision between whether to buy stocks or bonds all comes down to how much money one wants to make and how much risk one can handle. If one is very risk-averse, bonds are the best way to go because they have the least amount of risk involved as they are guaranteed to be paid back because of the indenture.Government bonds carry the least amount of risk out of all of the different ways to invest, and corporate bonds carry the second least amount of risk. If risk is not a big problem and one wants to gain as much money as possible, stocks are the best option. Common stocks are better to invest in if risk is not much of a worry at all, and they will make the most money. Preferred stocks are better for the stock holder who is moderately risk-averse but still wants to make the most money they can.
References
1.Lutts, Chloe. "Bonds Versus Stock Dividends."NASDAQ.com. NASDAQ, 11 Feb. 2013. Web. 14 Apr. 2015. <
2."Common Stock vs. Preferred Stock, and Stock Classes."InvestorGuide Complete RSS. InvestorGuide.com, 16 Oct. 2012. Web. 14 Apr. 2015. <
3."Preferred Stocks versus Bonds: How to Choose." Yahoo Finance. Investopedia, 12 Nov. 2014. Web. 14 Apr. 2015. <
4.Yang, Zhaojun. "Continuous-time Evolutionary Stock and Bond Markets with Time-dependent Strategies."African Journal of Business Management6 (2011).Academic Journals.org. Web.