Stock Markets and people crowding around in investing circles have a typical mob mentality – they do exactly what is predicted of them: go berserk. Stocks have always been the appealing part of the investing bandwagon and they manage to exude a glamorous appeal, which bonds just can’t think of exuding. However, come recession or some sort of a market fall and you would see everyone betting on bonds.
So, What Exactly Are Bonds?
Companies typically have two ways of raising cash when they need to expand their businesses or need it for a mind-boggling number of needs. One is by going public and diluting their ownership of the company to investors who would all pay a morsel (share price) and claim ownership: stocks. Another way of raising money is the age old method of borrowing: bonds.
Companies can borrow from the investors themselves and when each of the investors lends out even a small amount like $1000 it quickly rolls into a huge sum of money which the company can use for its expansion or other needs. Usually the federal government also borrows money from the investing public (these are the government bonds) for its own use. All of this money is returned to the public in a periodic manner with interest paid on the sum borrowed.
So typically, a bond is nothing but a loan that you hand out to companies or the government itself. The loan is paid back to you (an investor) within a scheduled time and at a specific, pre-determined interest rate (also known as coupon rate). The borrower (the company or the government) would have agreed in writing to pay back the borrowed amount (called as face value, in bond parlance) at a fixed date into the future which is when your bond matures ( the amount would have been paid back to you in full with Interest) and this date is called as the maturity date.
If you divide the bond’s coupon rate by its current price ( the price at which it is being traded on the secondary market), you would get what is known as the Current Yield – which is effectively the money you would earn if you purchase the bond on that day.
If the bonds are selling at a price that is lower than the face value, they are said to be selling at a discount – this discount narrows as the bond reaches its maturity and vanishes at maturity. When you purchase bonds which are trading at a price greater than their face-value you are buying these bonds at a premium. However, if the price of the bond and the face value are the same, then they are said to be at Par.
Since you always know how much you are owed exactly, these investment vehicles are less risky, more stable and hence they pay less compared to stocks. They are often called as fixed-income securities or debt-market instruments to reflect on the fact that they are predictable, more stable, pay less but don’t fluctuate wildly.
What’s the Difference Between Stocks and Bonds?
Between the two important investment vehicles – debt (Bonds) and equity (Stocks), there is this major difference. When you pick stocks, you claim ownership of the company, complete with voting rights and the works - you make money when the company you invested in makes money. When you buy bonds, you become a creditor to the company and in principle, when push comes to shove and when companies have to liquidate for some reason, the creditors are given the first preference and the bond investors are paid up first.
This post is part of the series: Bonds, Fixed Income Securities and Debt Markets
Everything about bonds, bond markets, interest rates, debt markets and investing tips can be found in this series.