Bonds vs. Stocks

Fundamental Differences Between Bonds and Stocks

The biggest difference that is usually cited between bonds and stocks is that bonds are debt instruments while stocks are equity holdings in companies. Bonds therefore represent a claim on a loan to the bondholder, either a company or the government, while stocks are a claim against the assets of a company essentially, involving a fractional ownership of it.

It may appear to be preferable to own something where one may benefit from being an entrepreneur so to speak by owning stocks, rather than just holding a debt obligation which will just pay out the debt plus the interest rate that has been agreed on, but bond ownership in itself is akin to being in business, the business of lending money specifically.

It is also not quite true that you are in business with the company when you own shares of it, even though this is technically true in theory. The value of your stock in a public company does not necessarily correspond to business conditions like ownership of private stock does, where the value of your shares do correspond to how the business is doing, its book value.

Book value is not directly correlated to stock prices though, even though investors may bid up or bid down the price of a stock using a number of fundamental calculations, including book value. The pricing of public shares is much more dynamic though and is driven solely by supply and demand of the shares, and this supply and demand fluctuates on a macro level in addition to the micro level that actually takes into account a company’s relative standing in the market and their fundamentals.

As it turns out, the main difference by far between stocks and bonds is that stocks are purely speculative instruments, where profits and losses are completely dependent upon the market itself, where bonds generally actually have a fundamental basis to them which is independent of market conditions, which are the terms of the bond, the principal amount and the income stream from interest payments.

Bonds can also be used to speculate, in this case speculating on future interest rates, but bond speculation is also married to fundamentals, the movement of these rates over time, and we can easily calculate how bond prices will change with specific changes in interest rates.

Why Bonds Are Less Market Driven

This is not to say that the market does not have its say with bonds, as there may be times where they will be more in demand, and this does affect the price, but one does not have to speculate at all with bonds and we can just hold them to maturity if we wish, which completely shields us from any market influence.

The amount that supply and demand can influence the price of bonds is also quite limited, unlike which stocks where this is the only driver of prices essentially. If people pile up on a stock that has little or no earnings, we can drive the price to earnings ratio through the roof if we want, and we have seen this happen in the past, particularly during the so called dot com craze of the 1990’s.

There is no essential connection with stock prices and anything, much like there isn’t with the intrinsic value of cryptocurrencies, which have no intrinsic value really, but this does not stop the market from bidding the prices on them up to any level they desire. It’s only when the buying slows down and enough people start taking their profits that there are limitations on price, turning the tide from accumulation to distribution, where supply starts to take over and demand wanes.

Stocks do have intrinsic factors that influence their prices, but only to the extent that market participants allow these factors to influence their buying and selling. Stocks could be bid up the same way as cybercurrencies have if people wanted to, riding the waves of momentum to the point where everyone who dares enter the market already has and there’s nowhere else to go from here but down.

The same can happen on the downside, where the fury of a selloff may take us to depths well below what people believe is the intrinsic value of a stock, because it’s the selling pressure that is driving this. We may want to describe this as the mere pressure of the market, but there’s nothing mere about this because these market forces are the entire deal when it comes to price movements.

Bonds, on the other hand, are fundamentally driven by intrinsic value, and while we still see excursions from intrinsic value with bonds, it is much more limited. We don’t have to move very far from this intrinsic value, based upon the income streams that bonds produce, before we start seeing some actual value being created from this perspective, where investors can swoop in and take advantage.

The reason for this is that bonds may be held regardless of market conditions, and if prices are bid down below intrinsic value, this creates more value in holding the bonds to maturity. If prices decline, this increases the yield of the bonds, and increasing yields mean that more interest income will be generated.

Conversely, if bond prices go up beyond intrinsic value, we will see the opposite effect, and this will also serve to stabilize prices, as we will reach a point where it no longer makes economic sense for the price to keep going up.

This all serves to make bonds more stable over time, at least when it comes to the quirks of the market influencing their value, although of course bonds are still subject to changes in value from fluctuating interest rates, but at least this is something we can plan for in advance and tends to be more predictable.

Stability And Potential For Growth

When we have an instrument that is more stable and predictable, this does mean that there is less risk involved, and it also means that there is less potential for return.

Holding bonds over time, particularly to maturity, can manage risk very well, and we can even get this down to what is considered to be a risk free investment, even though technically there is no such thing and there is always risk present with investments.

U.S. treasury bills are considered to be the standard here, and we will even compare investments to them, to see how they measure up to these so called risk free investments. The only risk with these treasury bills is default risk, in this case the chance that the United States will default on them. Since they are short term instruments, the chances of that happening is seen as so low that it isn’t even worth accounting for, which is actually the case.

The potential for growth with these debt instruments is also very low, as is the return relative to other forms of investments. While risk and return with investments are generally opposing factors, where an investment that has more potential for growth will be riskier, with bonds you can bet on this being the case, because risk is priced into the returns directly.

While you may find a hot stock that has a lot of potential for growth without a corresponding increase in risk, you won’t ever see this with bonds, because risk plays such a fundamental role in bond pricing. Longer term government issued debt pays out more than short term because the risk is a bit higher, and corporate bonds pay more interest because the risk is even higher. The relationship here is a direct one, taking into account all the risks present in holding the bond.

When money is loaned, regardless of the type of loan, there is a limited upside that is present. We may think that the upside is merely the borrower fulfilling their obligations, but there is also the upside of interest rates going down over the life of the loan, where the interest earned becomes more valuable and may even earn more in real terms over projections in inflation that are used at the time of the loan.

This happens with bonds as well, and bonds can therefore become more valuable if interest rates decline during the holding, especially if they decline more than what was expected. As interest rates go up, the value of the bond decreases.

We can speculate on changes to interest rates with bonds, and interest rates do change, but the potential for us benefiting from this on a percentage basis is quite muted, especially compared to what one may achieve with stock holdings.

Tradeoffs Between Bonds and Stocks

If you hold billions of dollars’ worth of bonds, it doesn’t take much of a move in your favor for you to make a lot of money, especially if you’ve leveraged your bond positions and only put up a tenth of the money.

Individuals do not leverage their bond positions though and movements in the pricing of bonds do not tend to produce anywhere near the potential for return on investment that stocks do, but they also do not have the same potential to incur losses as well.

Depending on one’s investment strategy and one’s risk tolerance, passive positions in the stock market can benefit from holding various proportions of one’s portfolio in bonds, to lend stability to the portfolio.

This is a very popular strategy in fact and while there are other and better ways to hedge stock positions, bonds represent the most popular one by far among individual investors.

With bonds, you give up a certain amount of potential for growth generally, but if the stock market is moving in the opposite direction than you want to see, downward with investors who are long the market, any positions that are more conservative is going to provide some relief.

Bonds may not go up anywhere near as much as stocks can, but they also don’t go down anywhere near as much either, and it’s the not going down so much that actually matters the most.

When we team this with the fact that you can just hold the bonds and collect the interest payments that are due over time, and also get your principal back in the end, with most bonds anyway, the amount of hedging that you can do with bonds comes very close to a complete hedge where risk can even be eliminated entirely with them if one is completely invested in them.

If someone holds their entire portfolio in U.S. government issued bonds, one can actually invest as close to risk free as one can get, even more so than with a savings account actually. Banks can go under, and you may get your money back, but your risk is limited to a U.S. government collapse for instance, that’s pretty solid indeed, as this is extremely unlikely at least in the near future.

From here, we can add whatever level of risk we desire and can tolerate, which, if we choose wisely and manage wisely, will spice up our portfolios and allow for various levels of greater potential for return.

If we are taking a long term view of these other investments, particularly with stocks, then it’s even more important to look to balance this risk with the more conservative and more stable features that bonds provide us.