Stocks Or Bonds: The Pros And Cons Of Each Of These Investments
This article is written as part of a DollarsAndSense Bonds Investing Education Series with Azalea Asset Management.
Most people invest through two main investment instruments – Stocks and Bonds. While they do share some form of similarities, stocks and bonds are inherently different.
Stocks represent ownership that an investor has in a company. This means that investors who own stocks in a particular company enjoy a share of any profits generated, either through dividend payouts or capital gains when the price of the stock rises. Investors partake in the long-term growth of the company.
On the other hand, investors who invest in bonds are investing in the debt obligation of the issuer (i.e. the company). The company issuing the bond is legally obliged to repay the principal amount borrowed plus interest, to the bondholders (i.e. the investors). Bondholders do not participate in the long-term growth of the company, and are primarily concerned with the ability of the company to repay bondholders the money it owes.
Before you embark on your investment journey with stocks and bonds, you should first understand the pros and cons of each of these investments, and how each instrument fits into your investment objectives.
# 1 Risk
Risk is one of the first things you should recognise when it comes to making investments. We always remind readers to “take care of the risk and let the returns take care of itself.”
While bonds are typically less risky compared to stocks, it doesn’t mean all bonds are less risky than all stocks. Let us explain.
Bonds are safer compared to stocks only when we are comparing them with regards to the same company. For example, if we were investing in both Singapore Airlines stocks and bonds, then our bonds investment may be safer compared to our stocks investment. However, this won’t necessarily be the case if we are comparing stocks of one company to bonds in another company. It could be that stocks of a good company may be less risky to own compared to the bonds of a company with poor fundamentals.
Nevertheless, stocks are generally considered riskier than bonds because of two main reasons. Firstly, if a company is forced to liquidate itself, bondholders will have superior claims to the company’s assets over shareholders. In other words, bondholders have to be paid first before shareholders get paid.
Secondly, shareholders are never guaranteed any returns from their investments. They generate returns when companies they invest in perform well. On the other hand, bondholders have to be paid the promised coupons and their principal upon maturity, regardless of how profitable a company is. Bondholders can also take legal actions against the company if these obligations are not fulfilled.
In general, bond investments are better for wealth preservation while stock investments are more useful for wealth accumulation.
Before investing into a bond, investors should do their own due diligence to ensure that they understand what is it that they are investing in, and the risks that they are taking. Information that they should be looking at include the financial statements of the company, the offering documents and ratings given to the bond by rating agencies such as Standard & Poor, Moody’s and Fitch, if available.
Ratings give an indication of the credit quality of a bond. However, not all bonds in Singapore are rated, and investors need to carefully assess their investments.
# 2 Expected Returns
Risk and returns are positively correlated. Since they are riskier, investors should expect higher returns from stocks as compared to bonds.
To further break it down, within each asset class, investors should also expect higher returns from investments into companies that are deemed riskier. For example, an investor who invests in a growth company should expect higher returns compared to investing in an established company. That’s because growth companies are inherently riskier to invest in.
The same rationale applies to bonds. Lower quality bonds, issued by companies with weaker fundamentals, would be expected to pay higher interest on their bonds in order to attract investors.
Bonds are usually the preferred investment instrument for investors seeking steady, visible, future cash flow. Bondholders know exactly when and how much they will be paid by the company for holding a bond. For stocks, future cash flows are much less certain since there is no obligation for a company to declare a fixed dividend to their shareholders.
# 3 Maturity Period
Unlike stocks, bond investments usually have a finite lifespan, and is said to have matured at the end of its lifespan. For example, if a company issues a 10-year bond, it will have to make periodic interest payments over the next 10 years, and to return the borrowed capital at the end of the 10-year period. Once all payments have been made, the bond matures.
Unlike bonds, stocks do not have a maturity period as it represents ownership, which is perpetual. Unless you sell your stocks, you will continue to own it indefinitely until 1) the company decides to privatise itself or 2) it ceases operations.
Do note that some bonds are issued as a “perpetual”. This means that the company is not obligated to redeem them at any point, but have to continue paying interests on it. In many cases, when a perpetual is sold, the issuing company includes a buyback clause which enables it to terminate the bond after a certain number of years.
# 4 Ability To Trade
The ability to divest your investments (i.e. sell it off) on the secondary market is an important aspect of investing.
For stocks, it’s pretty straightforward. Companies will have an initial public offering (IPO) when it will first sell its stocks to investors. After which, the stocks will be listed for trading on an exchange. Investors can continue to buy and sell stocks on the exchange.
Unlike stocks, bonds are less frequently traded on centralised exchange. In Singapore, there are only a handful of retail corporate bonds that are traded on the Singapore Exchange. Most bonds are traded through over-the-counter (OTC) markets. This is where investors buy and sell these bonds with registered financial institutions and dealers, rather than with other investors.
Here’s a quick recap of the pros and cons of stocks and bonds.
|Risk||Higher risk, more suitable for wealth accumulation||Lower risk, more suitable for wealth preservation|
|Expected Returns||Higher expected returns, less predictability over future cash flows||Lower expected returns, greater visibility over future cash flows|
|Maturity Period||Represents ownership in the company. No maturity period||Represent a debt claim on the company. Has a maturity period|
|Ability To Trade||Can buy and sell through centralised exchanges||Mostly traded in over-the-counter (OTC) markets|
Understand the Differences Before You Invest
Very often, investors only consider the merits of a company before investing into its stocks. However, by understanding the differences between both stocks and bonds, you can consider if bonds may actually be a more suitable instrument for your investment objectives.
At the end of the day, when it comes to stocks and bonds, neither can claim to be better than the other. As an investor, we should consider how both stocks and bonds can help us build a balanced, well-diversified portfolio, giving us both the returns that we seek, and the risk that we are willing to bear.
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