Generally speaking, bonds are a more conservative, less volatile investment than stocks. Bond returns may be lower than stocks, but they are almost guaranteed. We say “almost” because a degree of risk is attached to every investment out there.
A number of intricacies related to bonds become relevant for reaching specific investment goals, so we will take a closer look at the characteristics that make them preferable to stocks.
We will start off with stocks and bonds basics, so feel free to skip the first section if you already know what they are.
Stocks (or equity) are certificates that allow you to claim ownership of a very small portion of the company you invest your capital in. Also known as shares in a company, they are offered to willing investors when management needs to secure a fresh flow of funds to support their ongoing or future operations. The profit from equity comes from trading shares once their value in the market has increased. Some stocks pay dividends, which is a distribution of profits to shareholders, on a (usually) annual basis. However, this is not always the case.
Bonds (or fixed income securities) are financial instruments enabling investors to buy government (or corporate) debt. Bond issuers sell these instruments to raise money for large-scale projects, for example, the construction of a municipal building. The bondholder, or investor, will earn interest for lending the money, and these returns on investment are received on a regular basis (it can be monthly, semi-annually, or annually). However, the principal amount borrowed to the bond issuer is paid back to the investor at a fixed date in the future, also known as bond maturity date.
Risks and returns: Basics
Investment in stocks bears higher risks because the company that sold those shares to you could perform poorly. In that case, you lose your initial capital and there is nothing you can do about it. However, if the company delivers results, the value of its stock increases, and you as a shareholder can collect potentially high returns. Things move fast on the stock exchange, and fluctuation is a constant, so you are also guaranteed an emotional rollercoaster if you hold equity.
Buying bonds with your capital means you will face significantly lower risk. Although even governments can default on their debts, your return is almost guaranteed in the long run. And not only that, but this is a steady investment: you will also know the exact amount of money you receive, the maturity date, and you also collect your profit (interest) in the meantime. Some deem the low returns worth it.
Bonds provide a regular income stream
This feature of bonds makes them stand out not only against stocks, but also when compared to other asset classes like certificates of deposit, retirement plans, and commodities or other tangible assets. The income is interest paid to the investors until the bond matures. Now, the frequency of these returns differs. For example, corporate bonds can have monthly or quarterly interest payments while treasury bonds usually pay every six months. Also, don’t take this benefit of bonds for granted. There are a few types of bonds that pay the interest upon maturity along with the principal, typically treasury bills.
On the other hand, when it comes to profit from stocks, there are two issues. First, an investor can’t even rely on having an income because profits depend on making a buy/sell decision – which is a complicated conundrum in itself. And second, such income is not stable since opportunities come and go, sometimes within a short trading window. Investors in equity can’t afford to expect that the next chance to make a profit will be on the same schedule as what is comfortable for them.
Bonds protect accumulated wealth
The principal on a bond is collected after the bond maturity date and can serve to save money for a critical and forthcoming stage of life. For example, investors close to their retirement age can tie up their money in a bond that matures once they retire. Another instance where keeping accumulated wealth aside by investing in bonds is useful is when your kids are approaching their college years. It’s better than opening a savings account and you can plan ahead if you are aware that you will need extra funds at a certain point in your life.
Stocks are used to create or grow wealth – this is the general consensus. Prioritizing investments in equity is recommended for young investors who can face the risk of losing it all and starting from scratch. Even if you make all the right moves on the stock exchange, a market crash or a plunge in the economy (like the crisis we are experiencing at the moment) can quickly bring you large losses.
Bonds offset losses in a diverse portfolio
Diversification of assets is a ubiquitous risk management strategy practiced by nearly all investors. While there is plenty of room for all types of assets in a diverse investment portfolio, the relation between stocks and bonds is special. It has been pointed out by analysts that the performance of bonds is inverse to that of stocks. In other words, when bond prices are on the rise, stock prices fall; and the other way around.
This creates a solid risk mitigation logic – investors can back stocks and bonds with one another. Bonds will keep your capital safe if stock prices are down, and if stock prices are up, you can trade to cash in, while the other part of your money is tied up in bonds.
Bonds can be tax-free
Municipal bonds issued by local and state governments are often tax-free. Sometimes, specific criteria have to be satisfied for tax exemptions, but generally, this is true. Also, the interest from US Treasury bonds is taxable on your federal income tax returns. However, on a state level, no taxes are due.
Stocks are considered capital gains and they are taxed as such. Even if you are quick to reinvest them, they can be taxed as short-term gains. Stocks also attract a whole host of other commissions and fees.
Weighing out the risks: Bonds vs stocks
Don’t let elaborate financial charts fool you – the possibility of losing your investment is real with both bonds and stocks. It all comes down to the risk you are willing to take, or when you lose, what you can afford to lose. Let’s run a few comparisons to put these risks into perspective.
Interest rates on bonds
Apart from the prospect of your bond issuer defaulting on their debt, which is the worst-case scenario, the main risk to the value of bonds comes from interest rates. The Federal Reserve has traditionally cut interest rates to offset downward trends in the economy by stimulating spending. In other words – this aspect of managing risks is out of your control.
Plus, the value of bonds is closely connected with interest rates. If interest rates drop, the new bonds will have a low yield, so the value of your bonds will increase. This is the optimal scenario. However, if the bonds that are being issued at the present moment have a higher yield, the bonds you already hold will experience a decrease in value.
Unpredictable market for stocks
Regular fluctuations, both daily and long-term, make for a very volatile market at the stock exchange. This is not only guaranteed to influence your emotions (regardless of whether the price is going up or down) but also contributes to high risks. In specific terms, the worst possible outcome of investing in stocks is a drop in value after you have purchased them.
Do note that as the Fed’s policies on interest rates above, this one is also out of your control. Companies have been rising and falling on the trading floor for more than three centuries, so you should be prepared to lose everything if you go into stocks. The only upside is the high returns. That is, if you do manage to get them.
Bonds echoing stocks
In the world of investing, there is always a way to make a profit – you just need to find the right products. If you are interested in bonds that offer higher returns, you should turn to selling bonds. And if you are into stocks that bring reliable income, same as a bond would, then you can invest in dividend stock.
A successful company that is looking to motivate investors sells dividend stocks. The returns come in the form of distribution of profits to all shareholders based on the number of shares each investor controls. This falls along the lines of company policy. The risk is as with other stocks – the company might not perform well, but on the other hand, if they do have good results, the income stream flows in monthly and quarterly installments, or on a semi-annual or annual basis.
Why would any bondholder trade money securely invested in a bond? Well, they won’t. The type of bonds that are for sale on the market are not typical. These are high-risk, high-return kinds of bonds and conservative investors sell them to get rid of the risk. Since the return on these securities is uncertain, they are known as junk bonds. In a diverse portfolio, investors can include both low risk, low return, and investment-grade bonds as well as these volatile junk bonds to trade them for profit as opportunities arise.
When should bonds be the dominant asset in a portfolio?
If you know anything about investing, then you’ve probably heard about the “100 minus your age” rule. It refers to the portion of stocks relative to other assets in your portfolio. So, according to this rule, a young investor’s portfolio should hold 20% bonds and 80% stocks. On the other end of the spectrum, investors ready to retire should hold 70% bonds and 30% stocks.
Of course, opinions vary on this matter too. You can also hear folks who propose moving the scale to “120 minus your age” because life expectancy has increased, and because there are other types of assets for low-risk investment like index funds.
Speaking of which, a range of assets can improve diversification: it can be real estate, any of the investment funds (index, mutual, ETFs), other financial instruments, etc. Portfolios are tailored to meet long-term goals, and this can affect the role both bonds and stocks play in that mix of assets.
Bonds are the go-to asset for risk-averse investors who don’t mind the relatively low returns on account of facing considerably lower risks. As with any other investment decision, this doesn’t automatically mean that each bond is perfect. If you want to enjoy specific perks, like tax exemptions, that always calls for thorough research. Don’t go into extremes and invest in some stocks as well – diversification is the name of this game.