What Is the Difference Between Stocks and Bonds?

Investing involves financial instruments like stocks and bonds. Both are used to build wealth, but they represent distinct investments. Understanding these differences is important for portfolio construction and informed financial decisions.

Understanding Stocks: Equity Ownership

A stock represents ownership (equity) in a company. When an investor buys a share, they become a part-owner of the corporation, with a claim on its assets and future earnings.

Investors earn money from stocks in two ways. One is through capital appreciation, when the stock’s market price increases, allowing sale for more than paid. Another is through dividends, which are distributions of company profits to shareholders, paid quarterly.

There are two types of stock: common stock and preferred stock. Common stock represents basic ownership and grants voting rights on company matters, like electing the board. Preferred stock also represents ownership but does not carry voting rights. It provides a fixed dividend payment that takes precedence over common dividends.

Returns are taxed differently. Capital gains from stock sales are classified as short-term (held one year or less) or long-term (held over one year). Short-term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. Dividends are taxed as either ordinary or qualified, with qualified dividends generally receiving lower long-term capital gains rates if holding period requirements are met.

Understanding Bonds: Debt Instruments

A bond is a debt instrument; an investor buying a bond is lending money to a borrower. Borrowers can be corporations, government entities, or municipalities. The issuer promises to repay the principal amount (face value) to the bondholder on a specified maturity date.

Most bonds are issued with a face value of $1,000. In return for the loan, the issuer pays regular interest payments, semi-annually, at a predetermined rate called the coupon rate. This provides a predictable income stream.

Bond maturities vary. Bond interest income is generally taxable, though tax treatment depends on the issuer. Corporate bond interest is taxable at federal and state levels. U.S. Treasury bond interest is taxable federally but often exempt from state and local taxes. Municipal bonds, issued by state or local governments, often offer interest exempt from federal income tax, and sometimes from state and local taxes if the bondholder resides in the issuing state.

Differences in Ownership and Returns

Stocks and bonds represent different relationships between investor and issuer. Stocks signify an equity stake, making the investor a part-owner. This ownership provides a claim on the company’s future earnings and assets.

Bonds establish a creditor relationship, where the bondholder acts as a lender to the issuer. The bondholder does not own part of the entity but holds a promise of principal repayment and regular interest payments.

Returns differ between these instruments. Stocks offer potential for capital appreciation if company value grows and share price increases. Many stocks also provide dividends, variable payments from profits. Bond returns are generated through fixed or variable interest payments (coupon payments) paid regularly. Upon maturity, the bondholder also receives the principal, generally more predictable than stock returns.

Differences in Market Behavior and Risk Profile

Stocks and bonds exhibit different behaviors in financial markets, reflecting their structures. Stock prices are more volatile, experiencing frequent and significant fluctuations. These movements are influenced by company performance, industry trends, and economic sentiment.

Bond prices, while subject to market forces like interest rate changes, are less volatile than stocks. However, volatility can increase during rapid interest rate adjustments or economic uncertainty.

Each investment carries risks. Stocks face market risk, the possibility of losses from market downturns. They also carry company-specific risks, such as poor management or debt obligations. Return of principal is not guaranteed, as value depends on market demand and company success.

Bonds are subject to interest rate risk, where prices can fall when interest rates rise. Credit risk is another factor, the possibility that the issuer might default on payments or principal repayment. Other risks include inflation risk, where the purchasing power of fixed interest payments can erode, and liquidity risk, the challenge of selling a bond quickly without affecting price.

Differences in Priority of Repayment

A key distinction between stocks and bonds is apparent in financial distress, such as bankruptcy or liquidation. Bondholders, as creditors, hold a higher claim on a company’s assets compared to stockholders. This means bondholders are generally paid back before stockholders if a company liquidates.

The hierarchy of repayment dictates that secured creditors are paid first, followed by unsecured creditors, including most bondholders. Only after creditors are satisfied do stockholders receive any remaining assets. Within equity, preferred stockholders have a higher claim than common stockholders in liquidation, receiving payments before common stockholders, but after all bondholders and other creditors. Common stockholders are last in line and may receive little to nothing if assets are depleted.