What are bonds and are they preferable to investing in stocks?

We’re taking a look at what are bonds and what else investors should know about them.

Even if investors prefer to stick to higher-growth options such as equities, it is still worth knowing about bonds. This is because these asset classes can sometimes correlate with one another in certain circumstances. And they can give a useful insight into investor sentiment that may not be completely obvious if you just keep your eye on one of them.

What are bonds?

Bonds are debt securities issued by governments, municipalities, or corporations to raise capital. When you buy a bond, you are essentially lending money to the issuer in exchange for periodic interest payments (coupon payments) and the return of the its face value (principal) at maturity. The exact time and interest rate depends from security to security.

Bonds are often referred to as fixed-income securities because they typically provide a fixed interest rate (though some may have variable rates or no interest at all). The return on a bond is commonly measured as a percentage of the price issued, known as the yield.

Bonds that are company-issued can be bought directly from company or sometimes through exchanges. It is a similar story those that are issued by a government, they can be bought newly issued from the government or on public exchanges.

Should I invest in bonds or stocks?

It depends, but to cut to the chase, we think bonds are preferable for investors who are more risk-averse and want guaranteed income, but who don’t care so much about capital appreciation. Of course, there is nothing wrong with investing in both asset classes if it suits your portfolio. And the above principle is not necessarily true all the time, even if it is a majority of the time. But let’s look at the differences between stocks and bonds in more detail.

The most important trait in our view is that bondholders have priority over shareholders (or stockholders) in the event the issuer goes bankrupt. However, bonds are not risk-free; their value can fluctuate based on changes in interest rates and the creditworthiness of the issuer. And of course, there is no guarantee there will be anything back in the event a company goes bust. Just ask the creditors of Bonza.

Bonds are the safer, but more boring, option

But let’s cast aside the prospect of bankruptcy and look at other traits that make bonds more suitable for risk-averse investors, but less suitable for investors wanting a high return. Bonds are favoured by investors seeking regular income, as they provide predictable interest payments. They can serve as a diversification tool in an investment portfolio, especially for investors looking to balance the risk of stocks with more stable income-producing assets. They fluctuate a lot less, especially if they are issued by the government, although of course they still can prior to maturity. Ultimately, they tend to remain closer to their face value if held to maturity.

However, unlike stocks, which can appreciate significantly in value over time, the potential for capital appreciation with bonds is more limited. Furthermore, you share in none of the company’s profits. When you buy stocks, you become a shareholder and part-owner of the company. You participate in the company’s profits (through dividends) and losses (through capital gains or losses). If you’re a bondholder, you just get the promised repayments.

Is there any correlation?

An interesting question. Again, it depends, but it is generally the case that when the market expects interest rates to rise, there is a higher correlation because cash flows on both stocks and bonds get discounted at higher rates. According to Morningstar, correlation between stocks and bonds was 0.64 when interest rates spiked from early 2022 onwards, well ahead of the negative 0.24 between January 2009 and February 2022 when interest rates were low.

Of course, this is far from perfect, and indeed the idea of imperfect correlation of returns in asset classes is why it is considered common sense that investors should diversify their portfolios.

Conclusion

In summary, bonds and stocks serve different purposes in an investment portfolio. Bonds offer income, capital preservation, and lower risk, while stocks provide growth potential, dividends, and higher volatility.

The choice between them depends on your investment objectives, risk tolerance, and overall portfolio strategy. There is nothing stopping you from having both, and indeed, many investors hold both bonds and stocks to achieve a balanced and diversified investment portfolio.

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