What’s the Difference Between Stocks and Bonds?

Investing involves placing capital into assets with the expectation of generating a return. Financial markets offer various instruments for this purpose. Among the most fundamental investment vehicles are stocks and bonds. Understanding the distinctions between these two types of investments is crucial, as they represent different approaches to deploying capital within the market. This article clarifies the fundamental differences between stocks and bonds.

What a Stock Is

A stock represents a share of ownership in a company. This ownership typically confers certain rights, such as the ability for common shareholders to vote on significant corporate matters. These can include the election of board members, approval of major corporate policies, and decisions regarding the issuance of new securities or dividend payouts. Generally, common shareholders are granted one vote per share owned, allowing those with larger stakes to have a greater influence on company direction.

Investors primarily generate returns from stocks through two main avenues: dividends and capital appreciation. Dividends are distributions of a company’s profits paid out to shareholders, often on a regular basis. The taxation of dividends varies; “qualified dividends” are taxed at lower long-term capital gains rates (0%, 15%, or 20% depending on the investor’s income). Conversely, “ordinary dividends” are taxed at higher, regular income tax rates (10% to 37%).

Capital appreciation occurs when the market price of a stock increases, allowing investors to sell their shares for more than they initially paid. Profits from selling stocks are subject to capital gains tax. If a stock is held for one year or less, any profit is considered a “short-term capital gain” and is taxed at the investor’s ordinary income tax rate, which can be as high as 37%. However, if the stock is held for more than one year, the profit is classified as a “long-term capital gain” and benefits from lower tax rates of 0%, 15%, or 20%, depending on the investor’s income level. Stock prices can fluctuate significantly due to various factors, including company performance, broader economic conditions, and shifts in market sentiment.

What a Bond Is

A bond represents a loan made by an investor to a borrower, which can be a corporation or a government entity. In return for this loan, the bond issuer promises to make regular interest payments to the bondholder and to repay the original principal amount, also known as the face value or par value, on a predetermined maturity date. Most bonds are issued with a face value of $1,000.

The regular interest payments received by bondholders are commonly referred to as “coupon payments.” These payments are typically calculated as a percentage of the bond’s face value and are often distributed semiannually. Bonds have a “maturity date,” which is the date when the principal investment is returned to the bondholder. These maturities can range from short-term (one to three years) to long-term (10 to 30 years or more).

Interest income from bonds is generally considered “ordinary income” for tax purposes and is typically taxed at federal income tax rates ranging from 10% to 37%, similar to wages. However, the tax treatment can vary depending on the bond’s issuer. Interest earned from corporate bonds is usually taxable at both federal and state levels. Conversely, interest from U.S. Treasury bonds is taxable at the federal level but is exempt from state and local income taxes. Municipal bonds, issued by state and local governments, often provide interest income that is exempt from federal income taxes and may also be exempt from state and local taxes if the investor resides in the issuing state. While bonds are generally considered less volatile than stocks, they are not without risks, including interest rate risk and default risk.

Comparing Stocks and Bonds

Stocks and bonds represent fundamentally different relationships between an investor and an entity. Stocks signify an equity stake, meaning investors become owners of a company. In contrast, bonds establish a debt relationship, where investors act as lenders to a corporation or government. This core distinction impacts how investors generate returns, the level of risk assumed, and their standing in the event of financial distress.

Regarding potential returns, stocks offer the opportunity for capital appreciation, along with potential dividend payments. Bonds provide predictable returns through fixed interest payments and the repayment of the principal amount at maturity. This difference also shapes their typical risk profiles; stocks are generally considered to have higher potential returns but also higher risk. Bonds are typically viewed as lower risk investments with more modest, yet stable, returns.

The market behavior of these investments also differs significantly. Stock prices tend to be more volatile, experiencing sharper fluctuations due to economic news, company earnings, or market sentiment. Bond prices, while also subject to market forces like interest rate changes, are generally less volatile than stocks due to their defined payment schedules and maturity dates. In the event of a company’s bankruptcy, bondholders, as creditors, have a higher claim on the company’s assets than stockholders and are typically paid before shareholders, who are last in line and often receive little to no recovery of their investment.