What Are the Differences Between Stocks and Bonds?

Stocks and bonds are fundamental investment types. This article explores how they function as investment vehicles and highlights their core differences.

What is a Stock?

A stock represents an ownership stake in a company. This ownership entitles investors to a portion of the company’s assets and earnings. Companies issue shares to raise capital for operations, product development, or business expansion.

Investors generate returns from stocks in two ways. Capital appreciation occurs when the stock’s market price increases, allowing the investor to sell it for more than the purchase price. Dividends are distributions of a company’s profits to shareholders. While dividends provide income, they are not guaranteed and are declared at the discretion of the company’s board.

Common stock grants shareholders voting rights, allowing them to participate in company matters like electing board members or approving mergers. One share of common stock equates to one vote. Preferred stock does not carry voting rights but offers a fixed dividend payment and a higher claim on company assets than common stock in liquidation.

Dividends from stocks are categorized as either qualified or nonqualified. Qualified dividends benefit from lower tax rates, similar to long-term capital gains (0%, 15%, or 20% depending on income). To be qualified, the stock must be held for more than 60 days around the ex-dividend date. Nonqualified dividends are taxed at an investor’s ordinary income tax rate.

What is a Bond?

A bond is a debt instrument where an investor lends money to a borrower, such as a corporation or government. In return, the borrower promises regular interest payments and repayment of the principal on a specified maturity date. Bonds are fixed-income securities, providing predictable income streams through these interest payments, or coupons.

The coupon rate, established at issuance, determines the interest amount, usually paid semi-annually. At maturity, the investor receives the face value, or principal, back from the issuer. While bonds are often held until maturity, their market price can fluctuate on the secondary market based on prevailing interest rates.

Tax implications of bond interest vary by issuer. Interest from corporate bonds is taxable at both federal and state levels. Interest from U.S. Treasury bonds is taxable federally but exempt from state and local income taxes.

Municipal bonds, issued by state and local governments, offer tax-exempt interest at the federal level, and sometimes at state and local levels if the investor resides in the issuing state. Not all municipal bonds are tax-exempt; some may be subject to federal alternative minimum tax or be taxable if they do not meet IRS requirements.

Comparing Stocks and Bonds

Stocks and bonds represent different forms of investment, with distinct risk and return characteristics. Stocks signify ownership, while bonds represent a loan. This distinction dictates their roles in an investment portfolio.

The potential for returns differs between these asset classes. Stocks have the potential for higher returns through capital appreciation and dividends, reflecting company growth. These returns are variable and not guaranteed. Bonds offer lower but more predictable returns through fixed interest payments and principal return at maturity.

Stocks have a higher risk profile due to market volatility and company-specific performance. There is potential for loss of principal if a company performs poorly or economic conditions deteriorate. Bonds are less risky, providing a stable income stream and a defined repayment schedule. However, bonds carry risks, including credit risk (the possibility of the issuer defaulting), interest rate risk (where rising interest rates can decrease a bond’s market value), and inflation risk (the erosion of purchasing power of fixed payments over time).

Investor rights and claims also vary. Stockholders, particularly common stockholders, possess voting rights, allowing them a voice in corporate governance and major business decisions. In bankruptcy or liquidation, stockholders have a residual claim on assets, repaid last after all creditors, including bondholders. Bondholders, as creditors, have no voting rights but hold a higher priority claim on a company’s assets in bankruptcy proceedings.

Market behavior further distinguishes stocks and bonds. Stock prices are influenced by company performance, economic growth forecasts, and investor sentiment. They perform well during economic expansion. Bond prices are sensitive to changes in interest rates and inflation expectations. While their prices can fluctuate, bonds provide more stability during economic downturns, acting as a counterbalance to stock market volatility.