What Is the Difference Between a Stock and a Bond?

Stocks and bonds are two primary types of investments that form the basis of many portfolios, and they differ significantly in how they function and generate returns.

Understanding Stocks

A stock represents a share of ownership in a company. Companies issue stocks to raise capital for business operations, expansion, or other corporate activities.

Investors can potentially earn money from stocks through capital appreciation and dividends. Capital appreciation occurs when the stock’s market price increases. Dividends are distributions of a portion of a company’s profits to its shareholders, typically paid quarterly or annually. Companies are not obligated to pay dividends, and some choose to reinvest all earnings back into the business for growth.

Stock prices are influenced by company performance, industry conditions, and economic indicators. Strong company earnings or positive news can lead to higher stock prices, while disappointing results or economic slowdowns can cause prices to fall. Investor sentiment, which reflects collective confidence in the market, also plays a role in driving stock price movements.

There are two types of stock: common and preferred. Common stock grants shareholders voting rights on company matters, such as electing board members, and offers potential for higher returns. Preferred stock does not come with voting rights, but has priority over common stock for dividend payments and claims on company assets if the company liquidates.

Understanding Bonds

A bond represents a loan made by an investor to a borrower, which can be a corporation, a government, or a municipality. The issuer promises to pay interest over a specified period and repay the original loan amount at maturity. This makes bonds a fixed-income investment.

Investors earn money from bonds through regular interest payments, known as coupon payments. These payments are typically made semiannually or annually. The bond also has a face value, which is the principal amount repaid to the investor on the maturity date. The coupon rate, expressed as a percentage of the bond’s face value, determines the amount of interest the investor receives.

Bonds are issued by various entities. U.S. Treasury bonds, issued by the federal government, are among the safest investments. Municipal bonds are issued by state and local governments to fund public projects. Corporate bonds offer higher interest rates than government bonds due to the increased risk of default.

The price of a bond is influenced by prevailing interest rates and the issuer’s creditworthiness. Bond prices and interest rates have an inverse relationship. Credit rating agencies assess and assign letter grades to bonds, indicating their credit quality and the issuer’s ability to repay the debt.

Key Distinctions

Stocks and bonds represent different relationships between an investor and an entity. A stock signifies ownership in a company, making the shareholder a part-owner, whereas a bond represents a loan to an entity, making the bondholder a creditor.

Stockholders can profit from capital gains if the stock price increases, and they may receive dividends, which are distributions of company profits. Dividends are not guaranteed and are paid at the company’s discretion. Bondholders, conversely, receive regular interest payments, known as coupons, and the return of their principal investment at maturity. These interest payments are contractual obligations.

Stocks have higher risk and higher potential returns due to their direct link to a company’s performance and market sentiment. Stock prices can fluctuate significantly based on company news, industry performance, and broader economic factors like inflation or interest rates.

Bonds are lower-risk investments, offering more stable income streams. However, bonds are sensitive to interest rate changes, with their prices moving inversely to interest rates. Additionally, bonds carry credit risk. This risk is assessed through credit ratings, which indicate the issuer’s financial strength.

In the event of a company’s bankruptcy or liquidation, the priority of claims on assets. Bondholders, as creditors, have a higher claim on a company’s assets than stockholders. Preferred stockholders have priority over common stockholders, but still rank below bondholders.

A stock’s value is primarily influenced by the issuing company’s financial performance, earnings, growth potential, and overall market demand for its shares. Investor expectations for future profitability and growth prospects play a large role in stock price movements. Bond values, however, are largely determined by prevailing interest rates, the issuer’s credit rating, and the time remaining until the bond matures. A bond from an issuer with a higher credit rating or in a declining interest rate environment will generally be more valuable.