Understand the Differences between Stocks and Bonds as Securities Traded in Capital Markets
Capital Markets are simply markets where securities are bought and sold. Stocks and bonds are the typical securities people think of when discussing such markets as the New York Stock Exchange (NYSE). However, stocks and bonds represent very different types of claims to future cash flows of a corporation with different levels of risk to assess when deciding in which security to invest.
Shares of stock represent equity or ownership in a corporation which carry with them certain guarantees such as dividends, voting, liquidation, and preemptive rights. Common stock is considered residual interest in a firm which means stock value is based on the value of a corporation that is left over after superior obligations are met. Senior obligations can include debt repayments, taxes due, etc.. Common stock is the most prevalent security traded in Capital Markets.
Preferred stock is also represents ownership in a corporation with some important differences from common stock. Preferred stockholders are guaranteed dividend payments whereas common stockholders are paid dividends based on quarterly decisions of the board of directors. Although some boards of directors pay regular quarterly dividends, they is no guarantee that they will continue in the future; there is no obligation to pay dividends to common stockholders.
Preferred stockholders are given higher priority to dividend payments and proceeds acquired through liquidation. Essentially, preferred stockholders must be paid dividends before common stockholders are paid any dividends. However, if a corporation can not pay dividends to preferred stockholders, the firm is not forced into bankruptcy. In addition, preferred stockholders usually have neither a residual claim on assets nor voting rights.
As an ongoing representation of ownership in a corporation, stocks do not mature but continue to hold value as long as the firm still exists. Prices fluctuate in the market based on the company’s current profitability and expected future cash flows.
Unlike stocks which represent firm ownership, bonds are long-term securities representing debt. Debts are obligations to repay borrowed money. Debt repayments can be broken down into two parts. The principal is the amount borrowed and must be repaid in conformity to the terms of the bond. Interest is the amount paid over the principal and is usually expressed as a percentage to be repaid in compliance with the terms of the debt. When a firm fails to make payments to the bondholder, the firm is said to be in default which often leads to bankruptcy. Bonds usually carry maturities of 10 years or more which distinguishes them from notes which carry maturities of from 1 to 10 years. Both bonds and notes are called fixed-income securities because they pay specific, regular payments to their holders.
Stocks and bonds are the most common securities traded in Capital Markets. Whereas they both represent sources of capital to a firm, they are fundamentally different; stocks are ownership and bonds are debt. Which to use is a question of how the corporation wishes to raise capital and is a financing decision of a firm’s managers.
This post is part of the series: Capital Markets
Capital markets are simply markets where securities are bought and sold. There are three main types of securities traded in capital markets: (1) Money Market Securities, (2) Stocks and Bonds, and (3) Derivatives.