Bonds, like stocks, represent a major segment of the capital market and an important source of capital mobilisation for companies and, in the case of bonds, the government too. When businesses require substantial injection of long-term funds that can raise capacity or meet other strategic corporate objectives, they resort to the capital market. They have a choice of two options: issue shares or sell bonds. The government does not enjoy the window of share issue (a few people could buy up the State!), but has a lot of mileage in bonds. Whichever option they choose, the business of picking up the offer - investing - is that of the investing public. In deciding where to put money, the investor needs to understand how these investment options differ in features and their investment implications. It's only with such knowledge that it is possible to decide which offers to respond to and to what extent. While our other articles explain what bonds are and why bonds should figure in your investment plan, let's consider the fundamental differences between bonds and stocks here.
Bonds Are Debt, Not Equity
Perhaps the most-distinguishing features is in this fact that when you invest in a bond, you are a creditor to the issuer of the bond. The instrument you receive is more of an IOU, acknowledging the indebtedness of the issuer (borrower) to you and stating a repayment date and what interest you will be receiving, including the interest payment interval. This makes the payment of both principal and interest obligatory, meaning that they do not depend on whether or not the company makes profit (if a corporate bond). The company has to pay interest when due and repay principal at maturity, and none of this requires the discretion of the board of directors - as they have over dividend payment. If the company runs into difficulties and is unable to pay, when it comes to liquidation, the bondholder, as creditor, has a superior claim over the assets of the company. The interest of the shareholder is subordinated to his. Any outstanding interest and principal will therefore be repaid, before the ordinary shareholders can hope for any benefit.
The shareholder, you know, has ownership (equity) interest: he is a co-owner of the business. Consequently, he has a voting right, giving him a voice in the business, which a bond doesn't have (the latter is an outsider, his loan notwithstanding). While shareholders have no guaranteed returns (dividend can be zero in a year), their is no limit to what they can earn. When the business is very good, they can earn outrageous returns in dividends, because they are risk-takers. Bondholders have a fixed income, which is not increased, even if the company performs exceedingly well. The bondholder however enjoys that feature of a known, steady income flow, which allows for better planning. And when business is bad and shareholders go lean, the bondholder is unaffected. However, once the bondholder has received interest and repayment of principal, the chapter is closed. The shareholder, in constrast, has residual interest. If the business is liquidated, he shares in whatever is left after creditors have been paid off. There again, there is no limit. If the net assets are worth much, his share can be substantial, even if a bondholder had put in much more money in the company.
Defined Term
This is another significant difference: bonds have a definite term (only few exceptional cases of perpetual bonds). Even if the holder wished at maturity to continue to hold the investment (he's enjoying his interest income, for example), he cannot. He will rather purchase another bond. That's different for shareholding. If you love your company and don't sell your shares, you are a member - a part-owner - for life. It doesn't expire or mature. It's only redeemable preference shares that can be redeemed. Ordinary shares are outstanding indefinitely.
Different Risk Concerns
Stocks prices are highly volatile, leaving the stockholder gaping for breath, sometimes. He has to follow prices whose movement can be triggered by any minor development. He tracks company performance since even the shifts in rate of earnings growth, for instance, could be a reason for price to race. Such worries are not for the bondholder. Bond prices are less volatile. If government bonds, like the FGN bonds, there is hardly any earnings growth or profit performance to worry about. Even when corporate bonds are bought, the concern is more about default risk, which arises only from corporate inability to pay interest or principal and these arise if the company is truly in dire straits. Stockholders worry about the least developments concerning the company.
Blending all Together
In a sense, shares and bonds represent different sides of the spectrum. That should be an investment advantage. Given the differences between these investment options,
it's easy to see how they complement each other. While shares open you up to the potentials of relatively high returns, albeit with increased risks, bonds cushion the risk but offer limited returns. Those returns returns are however steady and predictable, meaning that you can have a source of regular earnings when you include bonds in your portfolio. In effect, it all adds to the opportunities available to you to structure your finances roundly, in a way that leaves you comfortable, irrespective of the turn of events. It simply takes a deliberate process, tweaking in the right places, taking consideration of all the critical factors. While a perfect position can hardly be ever reached, you will possibly realise that you can consistently improve your situation, just by taking some pains to do the right things.
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