Stocks and bonds are the most popular investment tools among savers: but what are the differences between the two? Here’s how they work.
Most investors are familiar with two categories of financial investment products: stocks and bonds. However, for average consumers and savers, it is not always easy to understand the difference between bond and stock, especially because we are talking about widespread but often confused concepts, despite representing very different products and purposes.
Before starting to invest in the financial markets, it is therefore necessary to understand the difference between stocks and bonds and which of the two securities is more convenient to invest in at a given moment in history. Both, in fact, can be defined as "securities", that is, a financial instrument through which the investor uses a part of his capital to purchase a portion of debt or capital of an entity or company: in the first case we speak of bond securities, in the second of equity securities.
But let’s go further and understand how stocks and bonds work and what are the basic differences to know.
What are stocks and how do they work
Stocks are financial instruments that allow investors to participate in the risk capital of a company. In simple terms, the stock represents a share of ownership of a company. When a shareholder comes into possession of a share of the capital, he or she becomes a shareholder of the company.
As such, the shareholder participates in the economic activity of the company, receives its fruits (through the distribution of dividends) but bears the risks in the event of losses. Risks, however, that are limited to the value of the shares owned.
A share is therefore the minimum quota into which the share capital of a joint stock company, limited partnership by shares, cooperative or limited liability companies is divided, as established by the Civil Code (articles 2346-2348) in Italy.
Rights and obligations of the shareholder
Shares are securities easily transferred to other parties and attribute to the holder rights and obligations, proportional to the share of capital owned.
Therefore, the shareholder:
- has the right to receive dividends, if distributed;
- has the right to vote in meetings;
- can consult the company books and challenge invalid meeting resolutions;
- may suffer the risk of losses, limited to the value of the shares held.
Categories of shares and their functioning
The company may issue special categories of shares that differ based on the rights they incorporate, the circulation regime, and the market on which they are traded:
| Shares | Characteristics |
|---|---|
| Ordinary shares | offer the holder administrative and patrimonial rights, such as the right to participate in ordinary and extraordinary meetings, the right to share profits and a share of liquidation in the event the company were to be dissolved |
| Savings shares | do not offer voting rights but have economic privileges (dividend distribution) |
| Preferred shares | give priority over ordinary shareholders in the distribution of profits and in the reimbursement of capital upon dissolution of the company, in exchange for a limitation of administrative rights |
| Increased and multiple voting shares | attribute an increased vote for each share held |
| Job rights shares | shares attributed to the holders of the shares reimbursed in the event of a real reduction in capital implemented by reimbursement of the nominal value of the shares |
| Registered shares | shares registered in the name of a natural or legal person |
| Beamer shares | shares that transfer the rights incorporated with the delivery of the title |
| Listed shares | shares whose trading (purchase and sale) takes place on the financial market |
| Unlisted shares | shares whose trading takes place through private agreements |
Shares can be traded:
- on regulated markets, which guarantee greater transparency on share issuers;
- in multilateral trading systems (MTF)
- by systematic internalizers: banks and other intermediaries authorized to provide the service of trading financial instruments on their own account, in execution of orders from clients;
- over-the-counter (OTC), outside of any market.
Value in the stock market
The stock market is that portion of the financial market where listed companies exchange their share of the company, called floating, for a certain quantity of money. The buyer of these shares obviously expects a return from this sale which is represented by the dividend, that is, 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, that is, we earn €1. If we had 1,000 shares, we would have earned €10, if we had 10,000, we would have earned €100, and so on.
As we can see, the share is equal for all shareholders and proportional to the number of shares they own. This is the basic principle why shares are a financial asset, that is, they have the underlying interest rate as 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).
What are bonds, instead? And how do they work?
A bond is a credit instrument that guarantees the purchaser the right to receive the capital paid at maturity plus interest (represented by coupons).
Conversely, the entity that issues it (a State, a public body, a private company or a supranational organization) is the debtor and uses the sum received to finance itself.
Each bond must indicate the name of the institution or issuing company, the overall size of the loan, its duration, the nominal value, the interest rate and the repayment method.
We can also classify bonds based on some characteristics:
| Bond | Characteristics |
|---|---|
| Ordinary bonds | Credit securities that give the holder the right to receive the reimbursement of the nominal capital at the maturity of the bond loan plus a remuneration in the form of interest in the form of periodic coupons |
| Structured bonds | Securities composed of an ordinary part with a predetermined return and a variable part, derived from the performance of a particular index |
| Convertible bonds | Securities that give the right to become a shareholder of the company by converting the debt security into a stock |
| Government bonds | Issued by a State, to meet public debt. They are characterized by different maturities |
| Indexed bonds | They are bonds whose interest rate is variable (for example linked to the trend of inflation) |
How to buy bonds
Bonds can be purchased on the primary market, by subscribing to the securities at the time of issue, or on the secondary market, i.e. on the stock exchange (for example on the MOT in Italy).
The bond issue can take place at par, i.e. at a price equal to the nominal value, or above or below par.
We speak of above and below par respectively when the bond is bought at a price higher or lower than the nominal value of the bond.
The issue below par is, in fact, the most frequent case: the difference between the price paid and the nominal value, which is also, generally, the reimbursement price, constitutes a integration to the nominal rate of return of the security, thus making the subscription more convenient.
An example to understand
To give an example, a Bot (Buono Ordinario del Tesoro) is a Government bond for 1 year that delivers 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 yield. 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; therefore, the bond is that financial asset that has the coupon as the underlying interest rate.
Differences between shares and bonds
After having seen in detail what shares and bonds are, it is easier to understand the differences between the two financial instruments.
| Shares | Bonds |
|---|---|
| Holder is a shareholder of the issuer | Holder is a creditor of the issuer |
| The Dividend is due if the company distributes the profits | Interest is due in the cases and in the ways provided for by the title |
| Dividends are higher if the company has performed better | If interest increases, the price of the bond falls (and the investment becomes riskier) |
| The maturity is indeterminate; however, the shares can be sold on the market | The maturity is predefined and established by the security |
| Expectations of return are higher and depend on the performance of the issuer | The return is contractually defined (return of capital and payment of coupons) |
From a practical investment perspective, the biggest difference between the two markets is certainly the “risk” component. Doing a quick logical work, would it be riskier to lend money to a company or to lend money to a government? Who is more likely to fail? The company has a risk profile that is certainly higher than that of a government, therefore the “risk premium” is certainly higher than that of a government. This means that the return of a stock is certainly higher than the return of a government bond.
High risk corresponds to high return, while low risk corresponds to low return, this is the main rule of financial markets and that ensures that markets perform their function: that of circulating capital and, therefore, of refinancing 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.
Is it better to invest in stocks or bonds?
The choice of an investment must always be preceded by an analysis of the investor’s expectations and by the attitude to risk.
In asset allocation strategies, stocks and bonds are combined in portfolios in order to balance the needs of capital protection with those of return. In the common imagination, in fact, bonds represent a less risky investment than stocks.
However, this is not always the case. Bonds can also present risks related to:
- the reliability of the issuer (credit risk);
- the time, i.e. the duration of the bond;
- the exchange rates, in the case of securities issued by foreign entities.
To establish whether it is more convenient to invest in stocks or bonds, we must refer to one of the fundamental principles of economics, that of "opportunity cost".
In his famous book "There’s No Such Thing as a Free Lunch", Milton Friedman, Nobel Prize winner for Economics in 1976, noted that what may be free for an individual, in reality always hides a cost: the price paid by society in giving up the opportunity to allocate the same resources to alternative uses.
Original article published on Money.it Italy. Original title: La differenza tra obbligazione e azione negli investimenti finanziari
