Understanding equity vs. debt investments
When it comes to investing there are myriad investments available, but they all essentially fit into one of two categories: equity or debt.
Stocks are equity investments. When you purchase a stock, you buy a financial stake in a company. As a shareholder, you literally own a piece of the business! Your ownership entitles you to profit sharing, voting rights, and often dividends.
When you own stocks, your returns are not guaranteed, but they are also unlimited. If the value of a company rapidly appreciates, so does the value of the shares you own.
Bonds are debt investments. When you purchase a bond, you are lending money to a corporation, municipality, or government. Instead of owning a piece of the organization, you are lending money that the business or organization agrees to pay back on a set term at a specific interest rate.
Bonds are considered less risky than stocks because they generate a fixed return on a fixed schedule, and your original investment capital is returned to you at the end of the term. In other words, you know exactly how much you will make from your bond, and exactly when.
Since bonds are so predictable, their value tends to be less volatile than stocks. Even when companies are liquidated bondholders tend to be paid before shareholders.
Since bonds are so predictable, their value tends to be less volatile than stocks. Even when companies are liquidated bondholders tend to be paid before shareholders.
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How do stocks and bonds work?
When you buy bonds, you are guaranteed a rate of return on your capital (called the bond coupon), and that your principal balance will be repaid to you at the end of the term (called the maturity date).
Short-term bonds have timelines of less than two years, mid-term bonds have maturity timelines of two to 10 years, and long-term bonds can be 10, 20, or even 30 years away from maturity. Stocks, on the other hand, have no timeline for expiry. They exist so long as the company exists and is trading on the public stock exchange.
The coupon or coupon rate of a bond is the interest rate. This is the investor’s guaranteed rate of return. You can calculate the coupon rate by dividing the annual payments by the value of the bond. The coupon is typically paid on an annual basis, but some pay bi-annually. If you own a bond ETF that contains a mix of short-, mid-, and long-term bonds, you will likely receive a distribution payment each month.
While a bond coupon is like a stock dividend in the sense that you receive a distribution for holding the investment, only the bond coupon is guaranteed, while dividends are not. Companies may cut or eliminate dividends at any time, or they can also increase them.
Bonds are typically held for the long term, but investors can sell them on the market if they choose to. The market price of a bond ETF or individual bond is determined by the coupon rates, time until maturity, and credit risk of the bond issuers. This is similar to how the market price of a stock is determined by the dividend, historical performance, and future expectations.
How do interest rates impact bonds?
The value of a bond, as well as its coupon rate, is largely determined by the interest rates set by a governing body like the Federal Reserve or the Bank of Canada. If interest rates are high, then bonds pay high-interest rates to remain competitive investments. If interest rates are low, then bonds also tend to pay low-interest rates.
Bonds are more favourable when interest rates are high because they offer relatively low-risk, high-yield returns. When interest rates are low, bonds are less attractive and investors tend to look for higher-yielding investments, such as stocks.
The coupon of a bond is fixed, so if interest rates increase the bond will return below market rates. This is the problem bond investors are facing now that a rise in interest rates is expected after many years of low rates.
On the other hand, bonds are valuable investments when rates fall. If you get a high-yielding bond and interest rates are cut, your bond will continue to pay that high-interest rate even as it becomes more difficult to find high-yielding investments elsewhere.
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Risks of stocks vs. bonds
There is no such thing as a risk-free investment, but the risk profiles of stocks and bonds are very different.
When it comes to stocks, both your return and investment capital are at risk. It’s possible the stock you buy will return nothing. It’s also possible you may lose your original investment! The riskiness of a stock investment depends on the company you’re investing in. Some stock investments, such as blue-chip companies, are considered very low risk, while others, such as penny stocks, can be extremely volatile. The inherent riskiness of a single stock depends on the company itself, as well as the industry and market it operates in and how that is influenced by geopolitical and broader economic factors.
When it comes to bonds, there are a few different types of risk: interest rate risk, default risk, and prepayment risk.
Unlike stocks, you’re generally not at risk of not getting a return or losing your capital investment with bonds. Instead, you’re taking on the risk that your money will be tied up in a bond while interest rates rise, and you won’t be able to use the money to get higher returns elsewhere. This is called interest rate risk.
Not all bonds are rated equally, however. It is possible the borrower will not repay the money you lent to buy the bond, and you will lose your investment capital. This is called default risk.
Finally, sometimes the borrower will elect to pay off their investment. This is the opposite of default risk and is called prepayment risk. Borrowers have the incentive to repay higher-interest loans, like bonds, if interest rates decrease. This is another reason low-interest rates are not great for bond investors.
When to buy bonds vs. stocks
Both stocks and bonds are necessary to create a well-balanced, diversified investment portfolio. Typically, how much of your allocation goes to each depends on your individual risk tolerance, your age, and your investment goals. You should consider adjusting your asset allocation every three to five years to reflect your changing circumstances, needs, and lifestyle as you near retirement.
Generally, you’ll want to avoid buying bonds when interest rates are rapidly increasing. Instead, you can wait until interest rates stabilize. Conversely, it’s almost always a good time to buy stocks, especially because the stock market is considerably more volatile than the bond market, making it much harder to choose optimal times to trade.
Regardless of how the market is performing, however, you should consider adjusting your asset allocation every three to five years to reflect your changing circumstances, needs, and lifestyle as you move closer to retirement.
The younger you are, the more risk you can afford because you have more years until retirement. You might choose to forego holding bonds in your portfolio entirely and only focus on stocks.
As you age and near retirement, you will gradually reduce your exposure to stocks and add more fixed-income investments to your portfolio. Bonds offer guaranteed income, so they are more appropriate for low-risk investors or individuals close to retirement.
When deciding on an asset mix, the best thing you can do is diversify your investments in a way that meets your financial goals.
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