Back to basics: what is the difference between a company’s stocks and bonds?
Stocks and bonds represent two different ways of funding companies (and governments in the case of bonds). They’re very different approaches and satisfy different investing goals.
As we’ve discussed, bonds are a loan to the company issuing them. Its creditworthiness determines how much of an interest rate it has to pay to its bondholders. The less likely a firm is to default (not pay) on its bonds, the lower its interest rate will be.Interest payments are made on a scheduled basis until it’s time to pay back the principal, or amount of the loan. Sometimes a company can pay back the bond early using a “call” feature to call the bond back. Other bonds are issued without the call feature and can only pay back the principal at the termination date.
A bondholder does not participate in the growth of the company, if there is any.
They receive a steady stream of income from the interest payments. If they like, they may continue to buy the bonds of a particular company as previous bonds mature in order to continue receiving interest income.
In the event that the company defaults on its obligations, bondholders are ahead of stockholders in line to salvage any money from the firm. For example, if a manufacturing company went bankrupt, its building and other physical assets can be sold, and bondholders could receive a portion of those proceeds.
Governments themselves can issue bonds, though not stocks. You’re probably familiar with US Treasuries from the federal government. Some US municipalities, as well as many foreign governments, issue their own bonds as well.
Bonds represent the debt of a company; by contrast, stocks represent ownership. A share of stock is a unit of ownership. If the company issued 100 shares (normally the number of shares is larger than this!) and you owned one share, you would own 1/100th of the company. Ownership typically allows the shareholder to participate in voting for directors or major changes to the company, such as liquidation, along with some other benefits.
Those who buy shares in a certain company’s stock participate in its growth, or its decline, through the share price.
A firm’s market capitalization (market cap) is the share price multiplied by the number of shares outstanding. If the 100-share company above was trading at $5/share, its market cap would be $500. Typically the companies listed on a public exchange for trading will have market caps in the millions, if not billions.
Because the share price is determined by supply and demand of investors buying and selling it on an exchange such as the NYSE or NASDAQ, it can often be very volatile. If a company goes bankrupt, usually common stock shareholders are wiped out because the bondholders take whatever proceeds are left.
Implications of the differences
Bonds provide a steady stream of income, and their prices rarely fluctuate. Often, even in the case of a bankruptcy, the bondholder may still get some of their principal returned. Therefore they’re good investments for someone who needs a regular income payments, or who is worried about losing money, for a near-term financial goal.
Stocks, on the other hand, reward investors for company growth. The investment value fluctuates, though it generally rises over time, making stocks a good fit for long-term goals. If the company goes bankrupt, the investment is usually worthless to the shareholder (and can be written off on the tax return.)
Bonds represent the debt of a company, and stocks show ownership. They are both ways to fund a company, depending on your financial goals and tolerance for risk.
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Originally published on www.fabfemfinance.com.