The Basics: Key differences between shares and bonds
When you first start reading about financial markets there are lots of terms that may be unfamiliar. Two that you’ll hear mentioned a lot are ‘shares’ and’ bonds’ – they are often featured in the same articles by financial journalists and economists. We look at the similarities and the key differences between the two.
Shares are part-ownership in a company, Bonds are IOUs
Firstly, let’s clear one thing up, shares and stocks are one in the same – stocks is the term more commonly used in the US and shares here in Australia.
Now back to shares and bonds …they are both types of securities, but they have very different characteristics and behave very differently. Simply put, when an investor buys shares they are buying part of a company; when they buy bonds, they are lending money to a company.
The basics of shares:
A share is a stake in the ownership of a company; it is a security that is also sometimes referred to as an equity. When a company issues shares they decide to sell a certain amount of ownership in their company. By issuing shares the company is giving the investor a claim to the company’s earnings and assets.
Investors generally buy and sell shares on an exchange, such as the ASX. Some companies pay out profits to investors in the form of dividends. However, dividends are not certain, over time they can be increased, decreased or not declared at all.
Shares can be very volatile and sensitive to the profitability of the company and macro and micro economic factors. Geo-political circumstances and overall market sentiment can also affect their performance. The upside of shares can be phenomenal, but the downside can be devastating. Share investors can benefit significantly if the company performs well, however, they also run the risk that the company performs poorly and the share price declines significantly, or in the worst case scenario, the company goes bankrupt.
Shares are perpetual investments – from when a company first issues shares it continues to evolve, and its share price continues to fluctuate. It takes an event such as bankruptcy or a takeover to cause the share life-cycle to end.
Share investors have a lot to think about:
The basics of bonds:
Bonds are a loan the company enters into with the investor. The company agrees to pay back the money lent by the investor on a fixed date AND make regular interest payments. Bonds can be issued by a company, a government or other entity looking for financing. Bonds sit higher on the capital hierarchy, which means bond investors get paid back before share investors, should the company default. This generally makes bonds a less risky investment than shares.
Unlike share investors who have many things to consider, bond investors tend to focus on the core financials and have one primary focus: ‘Will this company pay its coupons and repay my principal at maturity?’
The capital hierarchy
Fixed Coupon Bonds
Many bonds have a fixed coupon rate. Fixed coupon bonds have a fixed-rate of interest over the life of the bond. In addition to this fixed rate of interest, bonds have a fixed period of time after which the bond issuer will repay the bond’s initial loan amount or ‘face value’ (note: the face value of all XTBs is $100).
Floating Rate Notes
Other bonds may have a floating coupon rate, these are often called Floating Rate Notes (FRN). FRNs pay a reference rate, such as the Bank Bill Swap Rate (BBSW), plus a fixed margin above that reference rate. For example an FRN may pay BBSW + 1.00%. When the reference rate changes, the coupon rate changes to reflect that change. In Australia FRNs generally reference BBSW, which means that the FRN will reset every three months to reflect the prevailing BBSW rate on the reset date. Read more about FRNs
The bond lifecycle
Unlike shares, bonds are temporary instruments which have fixed lifecycles. Although elements of the lifecycle may vary from bond to bond, the stages are the same from issue to maturity.
An example of a fixed coupon bond:
- An investor makes an initial investment of $10,000 in a fixed-rate bond when it is first issued. The bond has a coupon of 5% and will mature on 21 September 2020.
- Whilst the investor holds this bond they receive annual interest (coupon payments) of $500.
- These payments are generally made twice a year for fixed-rate bonds and are on set dates which the investor knows in advance.
- If interest rates change (either up or down) whilst the investor holds this bond, they will still receive the 5% coupons each year.
- When the bond matures on 21 Sep 2020, the investor receives their $10,000 investment back and their final coupon payment.
- The lifecycle of this bond is now complete. The investor chooses to spend the money, or invest the money in another suitable instrument.
Fixed-rate bonds provide a known outcome with a fixed and regular income, so they are generally a lot less risky than shares and also less volatile, subject to there being no default. Investors are protected from huge downward fluctuations, but miss out on the large upswings that shares can provide. Because fixed-rate bonds provide a known outcome, they are a desirable asset to have in uncertain times or just to balance your portfolio.
Floating Rate Notes provide less certainty, as you don’t know exactly what income you will receive through the life of the FRN. However, you do know when and what will you get back at maturity, assuming no default.
Bonds lack the long term returns potential of shares, but for investors looking for income they can be a good solution.
Bonds may well be the less well known of the two securities. But, globally the bond market is more than double the size of the share market and locally, almost all of the top 50 ASX-listed companies issue bonds. They may be less well known, but bonds are certainly no less important.
Which is best for investors?
The old adage not to put all your eggs in one basket certainly rings true when looking at shares and bonds. Shares offer the potential for greater growth, but come with greater risks that you could lose money. Bonds are generally less risky, but offer less returns. Bonds can also protect your portfolio from the swings and roundabouts of the share market. They tend to perform in the opposite way to shares (they are ‘negatively correlated’ with shares), this means when shares are performing poorly, bonds tend to perform well. A well-diversified portfolio should incorporate both shares and bonds.
The information in this article is general in nature, it does not take into account the investment objectives or circumstances of any particular investor. You should consider, with or without advice from a professional adviser, whether an investment is appropriate to your circumstances.