Bonds vs. Stocks—What to Invest In?
Updated · Dec 06, 2022
Investments are a great and accessible way to generate additional income. With the right approach, you could build decent wealth.
But choose poorly, and you may lose everything in the blink of an eye. And while some things are out of your control, you need to pick your investments carefully.
To help you out, we discuss the performance of bonds vs. stocks.
Let’s start by defining the two concepts.
What Are Stocks?
Stocks are equity shares publicly available for trading. Companies use them to raise money without taking on debt. In exchange, they give investors an ownership stake and, depending on the equity account, other perks.
Some types of common stocks, for example, come with voting rights, while preferred equities include dividend payments.
With stocks, return depends on the business’ performance. If it prospers, investors’ capital grows.
If the company is going through financial hardship, everyone loses money.
What Are Bonds?
Unlike stocks, a bond is a debt instrument used in business and by the government to raise money. It’s a loan that the company pays back with interest over a predetermined period.
Investors receive interest payments in regular intervals and the principal amount at the end of the maturity period.
This type of investment is more secure than stocks, but it offers smaller returns. There are three main types of bonds:
The government issues different types of fixed-income securities. They are called treasury bonds, bills, and notes.
The main difference between them is the maturity period. It varies from a few weeks for bills to up to 30 years for bonds.
You can invest in bonds by going to the US Treasury's website, TreasuryDirect, by opening an account with an online broker, and through ETFs.
Corporate bonds are more volatile than government-issued ones. They’re still considered a more secure option than stocks.
That might be true for investment-grade bonds, which have low returns and risk. But companies offering high-yield bonds usually have lower credit ratings, so they are riskier.
Municipal bonds are essentially government-issued securities at the local level. In terms of security vs. yield, they are somewhere between the other two types of bonds.
Stocks vs. Bonds
Let’s go over the main differences between bonds vs. stocks.
Equity vs. Debt Financing
Businesses use two methods to raise funding: debt and equity financing.
With the first one, they take a bank loan or sell bonds and commercial paper on the debt market. The same goes for governments raising money.
Either way, the institution uses the gathered funds and pays them back with interest over a predetermined period.
With equity financing, companies sell ownership shares to investors in the form of stocks. They don’t have to repay the investors but give them an ownership stake.
If the business makes a profit, so do investors. And if the company is at a loss, the shareholders will be too.
So, the main difference between stocks and bonds is that one is ownership in a business, and the other is a loan to a business or institution.
Capital Gains vs. Fixed Income
There are two ways to make a profit from investments—capital gains and dividends.
While you can sell bonds on the debt market, that isn’t their main source of value. Since their price does not vary a lot, capital gains are typically small.
So, unlike stocks, bonds are in demand among conservative investors. They usually hold them until maturity and use them as a fixed income stream. In other words, they profit through interest payments.
Depending on the type of bond, you may receive interest payments in the form of dividends monthly, quarterly, semiannually, or only upon maturity.
Typically, stocks bring profit if you sell them at a higher price than you bought them, i.e., capital gains. Some companies also issue dividend payments.
On average, the stock market’s annual return is higher than the debt market’s. That said, there’s a peculiar relationship between the performance of stocks and bonds.
When the price of one security goes up, the other one decreases. This happens because the costs depend on investors’ demand.
In times of economic instability, more people look for secure investments. This leads to a greater interest in bonds.
During economic growth, businesses prosper, and stock prices increase. As a result, more people buy equity shares to capitalize on that growth.
Of course, that’s an oversimplified explanation of the phenomenon. There are many factors that influence market growth and prices.
Still, the link between the state of the economy and the price fluctuations of bonds vs. stocks is there.
Now, to complete the comparison, let’s go over the pros and cons of each type of security.
Stocks Pros and Cons
- Higher returns
- A better long-term investment
- More likely to take a loss in the short term
- Requires some experience to decide when to buy, sell, or hold
Bonds Pros and Cons
- A stable source of fixed income
- Lower risk of permanent losses
- Some types of bonds are a great guard against inflation
- Small returns
- Some risk of losses if the bond issuer cannot repay the principal
What Should I Invest in Right Now
As we mentioned, stock and bond prices fluctuate as a result of economic changes. With the looming crisis, you may be wondering, “What stocks should I invest in?” or “Should I buy bonds now?”.
While there’s no definitive answer, we can give you some pointers.
Bonds are a good investment for people with a conservative approach, nearing retirement age, or those who can’t afford to take big losses. In general, they are the more secure option.
In contrast, stocks are more volatile and have better returns on average. As such, they are suitable for younger investors with bigger risk tolerance.
Naturally, that’s a simplified generalization. There are high-risk, high-yield bonds and low-return stocks that pay dividends. Besides, return and volatility depend on a plethora of factors.
So, what are the best bonds and stocks to buy in the current economic situation?
Since the beginning of the Covid-19 pandemic, bonds have reached a negative 5.6% return. Still, treasury inflation-protected securities (TIPS) and Series I bonds are a good investment and guard against inflation.
Also, the return really depends on the stocks you buy. Some sectors and companies perform better during inflation than others.
Only time will tell how this economic crisis will play out. Still, history has repeatedly shown that a balanced portfolio has better returns in the long term than any of the securities alone.
So, the safest option is to build a diversified portfolio of stocks and bonds.
Investing is no easy feat.
For one thing, you need to understand how the different types of securities work.
Comparing bonds vs. stocks will help you choose the right investment. In the detailed guide above, we explained which one is suitable for different situations.
The bottom line is that you need a balanced portfolio for the best returns.
With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.