Investments: are Shares better than Bonds?

At a macroscopic level, most investors are familiar with two categories of investment products, or better yet, two types of markets, the stock market and the bond market. In recent years there has been an increase in the number of investments but there is still no knowledge of the basic concepts that must be taken into consideration in order to effectively evaluate when and how to invest in one or another market.

The stock market

This article mainly serves to provide very simplified but useful notions for understanding what the stock market is for, as in this case. The stock market is that portion of the financial market where listed companies (joint companies) exchange their share of the company, called the free float, for a certain amount of money. The buyer of these shares obviously expects a return from this sale which is represented by the dividend, i.e. that portion of profit which is proportional to the number of shares held and equal for all shareholders.

For example, we have 100 shares at €1 and the dividend is €0.01 per share. In total our dividend would be 100 shares x €0.01, i.e. €1 is earned. If we had 1000 shares we would have earned €10, if we had 10000 we would have earned €100 and so on. As we can see, the share is equal for all the shareholders and proportional to the number of shares held. This is the basic principle by which shares are a financial asset, i.e. they have interest rate underlying the dividend. The stock market therefore serves companies to raise capital from outside and this involves a dividend as a "reward" for those who "lend" money to the company (investor).

The bond market

Bonds are debt securities that are issued by states to finance their activities. Let it be clear from the start, this article is approximating in such a way as to make it clear what we are talking about and it is obvious that bonds are not only government bonds. When we hear about Bot, Btp, Cct, we are talking about bonds. The bonds therefore represent a debt security, an obligation on the part of the debtor to repay the predetermined principal plus interest at a specified maturity. To give an example, a Bot (Treasury bill) is a 1-year government bond with a yield of 0.5%.

At the end of the year, if we invest 100, we would have 100 plus 0.5% of 100, i.e. the invested capital plus the return. In total we would have 100.5 after one year. The time, which can vary from 3 months up to 50 years, is called maturity, while the yield is usually defined as coupon. If for the stock market we talk about dividends, for bonds we talk about coupons, so the bond is that financial asset whose underlying interest rate is the coupon.

The main differences between the two markets

The biggest difference between the two markets is certainly the "risk" component. In your opinion, is it riskier to lend money to a company or to lend money to a state? Who is most likely to fail? The company has a risk profile that is certainly higher than that of a state, therefore the "risk premium" is certainly higher than that of a state, i.e. the return on a share is certainly higher than the return on a state bond.

High risk corresponds to high return, while low risk corresponds to low return, this is the main rule of the financial markets and which ensures that the markets perform their function, that of circulating capital and therefore to refinance listed assets. When a State wants to raise capital it tries to offer a higher coupon, just as when a company wants to raise capital it will tend to offer and detach a higher dividend. This increase in returns corresponds to a greater risk undertaken by the investor.

The dynamics of "Flight to Quality"

The “Flight to Quality” indicates the propensity that the investor has for the good value for money offered by a market. For example, if the stock market yields the same return as the bond market, therefore with the same yield there is a different risk in favor of the bond market, investors will tend to buy more bonds in the bond market by selling equities at the same time. The act of selling a market, raising cash and buying another market, represents "the flight towards quality", a real migration of capital towards more attractive returns. Why talk about "flight to quality"? Because this is the premise of all the investment choices that all operators, both professional and non-professional, make to compose their long-term portfolios.

The current market environment, where we have a stock market crash and a sharp rise in government bond yields, is perfect to describe this phenomenon. For example, at the moment the flight to quality can be explained by security, i.e. by a strong outflow from risk markets such as equity markets for greater security which for the moment is represented by the currency market and the credit market, all while the government bonds increase their yields to make themselves attractive on the market again. This phenomenon, in addition to being at the basis of investment choices, is essential for carrying out intermarket analysis and trying to understand where the various markets will be able to allocate their capital.

Original article published on Money.it Italy 2022-07-12 08:57:00.
Original title: Investimenti: meglio azioni od obbligazioni?