Basic Differences Between Stocks and Bonds
Stocks and bonds represent two major financial asset classes. Stocks, or equity shares, represent an interest in a company. In public stock issuance, the company sells a certain number of equity shares to the public investment market through a stock exchange. Stock represents a percentage of ownership in the company. Unlike bonds, a form of company loan underwritten by lenders, stocks do not have a maturity date.
Because many bond loans pay regular coupon interest to lenders, they offer a reliable income stream to bondholders. Bond maturity describes the term of the bond loan. For example, short-term bonds are expected to return the investor’s principal investment within one or more years.
Publicly traded stocks rise and fall in price according to demand on a stock exchange, such as the New York Stock Exchange. When buyers outnumber sellers of any company’s common shares, the stock price rises. The current stock price is one of the variables used to value the company. Bond valuation, unlike stocks, trade according to the borrower’s credit rating, the interest rate environment, and the demand for the bonds in a publicly traded market.
Let’s say a borrower, called an issuer, needs capital. The company likes the idea of borrowing money at today’s very low interest rates. The company decides to call an underwriting firm to discuss terms. The underwriter evaluates previous bond issues of the company. Has the company paid interest on a timely basis? The underwriter notes that the company has always made regular, twice-yearly coupon payments to lenders. The company has always returned principal as bonds came due. Several reliable rating agencies, such as Standard & Poor’s and Moody’s, give the company an “A” (investment quality) rating. Perhaps the company would have a higher credit rating if there was not so much outstanding debt. The underwriter recommends a plain vanilla bond structure. The company issues new bonds and promises to pay a fixed interest yield for 10 years. The company backs the bonds with its full faith and credit.
According to Bond Valuation: Yield Measures and Term Structure, other borrowers issue zero coupon and deep discount bond loans. These bonds typically pay no current interest. They are offered at a deep discount to par value (100%, or $1,000 per bond). The investor receives a lump sum from the borrower when the bond reaches maturity. Because investors receive no current income from deep discount or zero coupon bonds, the borrower’s credit rating is an important consideration.
Bonds are also highly sensitive to interest rates. When interest rates rise, publicly traded bond prices decline. Deep discount or zero coupon bonds are especially interest-rate-sensitive.