What are bonds?
Bonds can be best described as financial instruments of debt which corporations and government agencies of all levels use. Bondholders are the investors in this case from which the issuer borrows money through a written contract. The issuer promises to pay the borrowed money plus interest to the bondholder at a previously agreed rate. The principal amount is the amount borrowed by the issuer.
Bonds are repaid through semi-annual payments called debt service. This consists of interest payments with the final one including the principal amount. They have a predetermined date of maturity after which the future interest payment stops.
Interest rates and bond prices are inversely correlated, which means bond prices rise when interest rates fall. Thus if one wants to sell their bonds before maturity, they have to sell them at a loss if their value goes down. Similarly, bondholders can receive capital gain, if the interest rates go down, driving the value of the bond up.
Different Types of Bonds
|High- Yield||They have a lower credit rating and possess a greater credit risk compared to investment-grade bonds; They offer higher interest rates.|
|Corporate Bonds||They are a type of debt securities issued by both public and private corporations.|
|Investment-grade||They have less credit risk because of their greater credit rating, compared to high-yield bonds.|
|Municipal bonds||These can be defined as a sort of loans that government entities take from investors. These are usually used for funding government infrastructural projects such as roads and bridges.|
What Are Equities?
Equities can be best described as shares in a company’s ownership. In other words, it’s the total amount of money that a shareholder receives when all of the assets of the company are liquidated and its debts are paid off. By investing in equities, one can earn profit either through stock price appreciation or through capital gains. Equities are usually high-return investment options but also expose one’s portfolio to a certain level of risk. This is why one should always gauge their risk appetite before investing inequities.
Categories of Equities
|Equity Mutual Funds||In this type of equity, capital from different investors is compiled, pooled, and invested in a myriad of equity and debt instruments. In a mutual fund, almost 60% of it is invested in different companies through equity shares.|
|Shares||These refer to partial ownership in a company. They are mostly traded via exchanges such as the New York Stock Exchange.|
Differences in Characteristics Between the Two
|Points of Difference||Bonds||Equities|
|Volume||The volume in the bond market is pretty high. It possesses a low net purchase pattern, which suggests that a strategy with a short-term horizon will be successful. Short-term interest fluctuations and arbitrage opportunities are the primary drivers of transactions.||The volume in Equities is pretty low. It possesses high net purchase patterns, which means that a strategy based on long holding periods will work wonders.|
|Exchange Rates||The bond market consists mainly of international investors who have a preference for stable or fixed exchange rates. Exchange rates like these help investors to benefit fully from investments in fixed interest securities. It also protects them from risk premiums in emerging market rates in the case of fixed exchange rates.||Investors in the equity are attracted to exchange rates which are floating. They do not prefer fixed exchange rates as it can undermine its competitiveness over time and have a negative impact on returns. With the depreciation of exchange rates, the value of the equity tends to remain the same.|
|Volatility||Bonds are one of the more volatile components of portfolio flows||Equities are the less volatile component of portfolio flows.|
|Crisis Situations||When hit by a crisis, bond holders are more likely to return their investments. Even default usually means delay and restructuring of payments.||During the crisis, equity holders can lose all the investments if the company goes bankrupt. Shareholders are usually the last in a compensation line.|
|Types of Investors||Investors in Bonds usually look at aggregates and indicators which are related to real yield. This can be anything from currency movements to current accounts.||In the case of Equities, Investors look at the equity valuation. This can include the movement of the equity market, financial results or their growth.|
Similarities Between Bond and Equities Markets
Aside from the various differences between the two instruments, there are a number of similarities as well.
Sensitivity to Changes In Interest Rate
Both the instruments react heavily to interest rate changes. With the changes in monetary policy, volatility for both securities increase. When interest rates rise – their prices usually fall. This is because of the discounting of cash flows at a higher rate, which provides more yield for bonds. For the stocks the higher rate – the higher price for companies debt, which definitely affects financial results. This also means that when interest rates fall, both securities prices can climb.
In the case of both bonds as well as equities, the returns depend heavily on the company’s performance behind the instruments. If the company performs badly, it will affect gains made from these instruments. Also, stockholders and bondholders do not directly benefit from the company’s future growth.
For investors, one of the toughest choices they have to make is to choose how much stocks and bonds they want to invest in. While there are no “one size fits all” answers, the decision depends on a number of factors. One should consider his/her age, experience as a trader or investor, investment philosophy, and other things.
This one of the reasons why many adopt a strategic asset allocation when adopting a long-term investing viewpoint. This easily determines what percentage of investments should be put in bonds and stocks.