Stocks and Bonds

In the financial markets, the most common forms of marketable securities are stocks and bonds. Though they have some similarities to each other, they differ greatly in many aspects. Broadly speaking, both financial instruments enable one to invest in corporations, public and/or private, with possible profitable returns in the future. Stocks (or shares), by definition, are shares of ownership in a company. By purchasing stocks in a company, the investor becomes a part owner, and thereby owns a percentage share of the company’s after tax profits.

Stocks/shares have two key characteristics: 1) they can be issued in small denominations: an investor can purchase as many or as few shares in a company as he/ she wants, thereby becoming a stockholder in that company and 2) they are transferable, which allows the investor to sell the stocks that he owns to someone else, generally through a stock exchange. Stockholders, by right of being part owner, have the power to elect the board of directors, and in addition, remove senior level managers or directors, who they feel are performing poorly.

Though they are part owners, stockholders have limited liability with regard to any losses that the company may incur. Under all circumstances, any shareholder can only lose as much as he/ she had initially invested to purchase the stock. Stockholders invest in stocks to gain from 1) dividends that the company declares from time to time and 2) appreciation in the trading price of the stock on the stock exchanges. Dividends declared by companies are by no means fixed or predictable, and depend among other things, on the distributable profits of the company.

Stock prices are primarily affected by the profitability of a company, the dividend yields of a company (rise in dividend yields give rise to higher stock prices), general market conditions (a bull market will produce higher stock prices, and vice-versa in bear markets), and interest rates (rising interest rates generally correlate with lower stock prices, since the cost of borrowing for companies becomes more expensive, adversely affecting company profitability).

Bonds, on the other hand, are “debt investments”. A bond is a form of loan. When a bond is issued by a company, or purchased by an investor, the initial issuer of that bond is the borrower [of capital] and the purchaser/holder is the lender. The issuer then owes the bond- holder a debt, and depending on the terms of the bond, is generally obliged to pay a certain interest rate until the money borrowed is paid in full on a pre-specified date. Bond prices rise hen there is a reduction in expected inflation, a decrease in expected interest rates, a fall in the price volatility of the bond, an increase in the expected return on the bond relative to the alternatives, stagnation of general business conditions, and a decrease in the government’s expenditure relative to its revenue. Bonds and stocks tend to have an inverse relationship. Generally, though not always, whenever stock prices rise, bond prices fall. In times of economic uncertainty and volatility, stocks become more and more unfavorable to investors, pushing them to invest in bonds in the process.

When interest rates are expected to fall, bonds become an attractive investment avenue and bond prices will rise.. Positive economic activity and growth on the other hand, tend to be greatly beneficial toward stocks. As economic growth increases, stock prices rise, but inflation also increases more often than not, and in such event, the government may apply anti-inflationary measures, raising interest rates, which in turn would lower bond prices. Hence bond prices and stock prices generally have an inverse relationship.

While stocks and bonds generally have an inverse relationship to each other, under certain circumstances, however, stocks and bonds move in the same direction. For example, during October of 2009, both stocks and bonds were rising at the same time, indicating that both interest rates and inflationary risks were low. With low rates and low inflation risk, investors were motivated to undertake risks at very low cost. Stocks were rising on expectations of economic recovery later in the year, and bond prices fell as their yields increased (bond prices and yields are inversely related).

The yield on the 2-year notes and 10-year notes, which are heavily influenced by the Fed-regulated interest rates and inflation expectations, respectively, increased from . 76% to 1. 4% and 2. 25% to 3. 93 during the same period, respectively. Concurrently, the S&P 500 had gained 4. 8%, rebounding 40% from March lows. Though stocks have statistically delivered higher returns in the long term compared to bonds, bond prices are less volatile.

The dividends paid out on stocks are uncertain and depend on the distributable profits of the company, the company’s investment plans and cash needs for the same, and other such factors. On the other hand, bonds generally make a pre-specified interest payout to all bondholders periodically, thereby ensuring an assured, known cash-inflow in the hands of a bond-holder. Further, on maturity of the bond, a pre-determined principal amount is paid out by the issuer to the bondholder, to purchase back the bond.

Hence, a bondholder who holds the bond to maturity, knows exactly how much he /she will receive both by way of interest as well as principal on maturity. This is completely untrue for stocks, where neither the dividend flow nor the capital appreciation is predictable with certainty. Bonds are therefore relatively safer investments for investors whose risk-appetite is low, whereas stocks with their higher prospective price appreciation together with dividend payouts offer a high-risk, high-return opportunities for those with high risk appetites.