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Two of the most recognized assets when it comes to investing, stocks and bonds — are often the building blocks of a solid investing portfolio.
However, there are many differences between the two, and it’s important to understand those differences before deciding how to allocate capital into these investment vehicles. For additional information, check out Benzinga’s recommendations for Best Online Brokerage Accounts and Best Online Stock Broker for Beginners.
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What is a Stock?
Stocks are fractional ownership of a company. When you are the owner of shares of stock in a company, you own part of the company. This is proportional to the number of shares the company has outstanding
What is a Bond?
Bonds are fixed-income securities that those who invest with fixed periodic payments and the eventual return of principal at the end of the tenure of the security.
In other words, a bond is an agreement between the bond issuer and investor. It specifies the fixed amount the bond issuer is obligated to pay the investor at specified intervals.
Stocks vs. Bonds: Equity and Debt
The underlying difference between stocks and bonds is in the way each of these instruments is structured. A company issues a share of stock to obtain capital for its business in return for giving away a piece of ownership in the company.
One share of stock represents one piece of ownership in the company, which is known as equity. This equity brings with it certain rights, such as the right to a portion in any distributions of income from the company to its owners (known as dividends), as well as voting rights for certain corporate actions such as changes in the management team or board of directors.
Bonds, while also designed to raise capital for a business or government, are pieces of debt sold with the promise of interest payments over the life of the bond to each bondholder. Unlike the equity which comes with being a shareholder, a bondholder is not privy to voting rights in a corporation but does gain the benefit of being the first to be paid back his or her investment before shareholders.
- Part owner of a company
- Investors benefit from the growth of a company.
- Profits are paid out in the form of dividends.
- Investors benefit from the interest paid on a loan.
- Interest payments are made in the form of coupon payments.
Stocks vs. Bonds: Income Streams
Stocks provide a variable income stream based on the appreciation in stock price and any dividend paid by the company to shareholders.
Since there is no limit to the amount a stock price can rise, the potential return from one share of stock is theoretically limitless. Stocks can be easily bought and sold at any time, making them liquid in the event that you need to quickly turn your shares into capital.
Bonds come with steady interest payments, which, depending on the bond, are made monthly, quarterly, yearly, or at some other time interval, with the principal bond payment repaid at the end of the bond term. This means, if you pay $1,000 for a bond with one year to maturity, you shouldn’t expect to get that $1,000 back until the end of the year.
However, you’ll receive regular interest payments over that period. The result of a steady income stream means interest rates on bonds are generally not as high as the potential return from the appreciation of stock prices, making the upside of owning bonds limited to their interest rate payments while stocks have unlimited potential as long as share prices continue to rise.
Risk with Stocks and Bonds
The share price benefit of being a shareholder also makes it a potentially risky investment. If you own stock in an underlying company and it begins to perform poorly or has financial trouble, the stock price will begin to depreciate, and with it, the total value of your stock.
This could cause you to lose some, or even all, of your original investment, making stockholders much more susceptible to economic changes and swings in prices. Alternatively, bondholders are guaranteed regular interest payments on their purchases, which, although usually at a lower rate of return than stocks, are made consistently throughout the life of the bond.
There does become a risk when a bond issuer cannot afford to make interest payments to bondholders, and in turn, defaults on its bond. Oftentimes, if an entity defaults on a bond, its bondholders still receive a portion of their original principal.
Both stockholders and bondholders fear the underlying company filing for bankruptcy. In the event this does happen, bondholders, along with all other creditors, are paid back their initial investment first, prior to stockholders. Sometimes, there is not enough money to pay back stockholders at all in the case of bankruptcy, making a bondholder more likely to recoup at least a portion of their investment in this worst-case scenario.
Risk vs. reward in stocks and bonds
Taxation with Stocks and Bonds
Taxation plays a vital role when determining the total return on an investment. Taxes on the appreciation of the value of stocks are dependent on the amount of time those stocks are held, with stocks held less than one year taxed as short term capital gains at the ordinary income rate, and stocks held more than one year taxed as long-term capital gains at a specified tax rate dependent on the investor’s tax bracket.
These capital gains taxes are not incurred until shares of stock are sold. Some companies offer a portion of their profits to stockholders in the form of dividends, which are taxed when they are paid out. Dividends are either taxed as ordinary income or as long-term capital gains, depending on several factors such as how long the stock has been held and the date the dividend was issued.
Taxation on bond interest payments is almost consistently across the board viewed as income by the IRS. There are several tax exemptions for bonds depending on their type, which can make bonds a much more tax-friendly investment.
For instance, treasury bonds are exempt from state and local taxes and municipal bonds are exempt from federal taxes.
Some municipal bonds are even known as “triple tax-free,” as they are exempt from taxes at the municipal, state, and federal level. It is important to understand all of the tax exemptions for bonds before making a purchase, as it could completely change the expected return from the investment.
Check out Benzinga’s picks for the best municipal bonds.
A balanced portfolio is one that contains both stock and bonds, because balancing the potential losses of investing in stocks with the steady stream of interest payments from bonds offsets much of the risk associated with stock investing. At the same time, both allow for the benefits of appreciation that stock market investing provides. Finding the balance between both asset classes are most definitely the key to investing success.