Equities vs. Bonds
What are “Equities and Bonds”?
Equities and Bonds are two of the most traded asset classes and are often combined together as part of a well-diversified portfolio. When buying equity in a company, the investor becomes a shareholder and can participate in the distribution of profits. When buying a bond, the investor becomes a creditor to the issuer and is entitled to a fixed interest along with the ultimate repayment of the principal. Equities (also known as stocks) are shares issued by companies and trade on an exchange. On the other hand, bonds (also known as fixed income) could be issued by companies or sovereigns and could be traded either publicly, over the counter (OTC), or privately.
Key Learning Points
- Equities are securities that offer ownership of a fraction in a company
- Bonds are fixed-income securities which represent a loan made by an investor to a borrower – usually corporation or government
- In the event of liquidation, bonds rank with higher priority than equities and bondholders are entitled to claim from the company’s assets before shareholders
- Typically, equities and bonds have a low correlation and when combined together in a portfolio can offer diversification benefits.
What are Equities?
In practice, when buying shares in a business the investor becomes one of the many co-owners of the company and usually has the right to vote at Annual General Meetings and other corporate strategy proposals (depending on the type of share owned). The benefit of being a shareholder is that the share price of the company may rise in value and the investor could sell making a profit (capital appreciation). Also, the investor may be entitled to participate in the distribution of company profits in the form of dividends or share buy backs. However, the downside of investing in equities is that there is no guarantee for future profits or that the investor could be able to redeem the amount invested. In addition, if the company goes into liquidation, shareholders are among the last to be repaid in the hierarchy of creditors.
What are Bonds?
Bondholders are effectively creditors to the company and are entitled to a regular interest payment (coupon) and the amount invested in full when the bond matures (principal). By investing in a fixed income security, investors are in a more secure position compared to equities in the event of insolvency or liquidation as they will be among the first who can claim from the company’s assets. In addition, if the issuer of the bond defaults on its debt, there may be a chance of recovery, whereas a share price can drop to zero. Bond investors pay a lot of attention to the credit rating of a security as an indicator of the potential risks involved with the investment. Overall, bonds should not be expected to offer the growth rate of equities, but rather provide a relatively safer source of total return and capital preservation features.
How to Utilize Them in a Portfolio?
Equities and bonds tend to have lower correlation as they respond in a different way to market events. Therefore they can complement each other in a well-diversified portfolio. While equities are the riskier asset and their return profile could be more volatile, bonds typically offer a smaller but more stable return. However, the right portfolio mix should be determined by the individual’s time horizon, objectives and risk profile.
The chart demonstrates the typically inverse relationship between equities and bonds. It compares the performance of the US S&P 500 equities index and a large bond index. In periods where equities outperform, bonds typically underperform and vice versa. Owning both asset classes can potentially offer a stable return in investment even in economic downturns (bonds) as well as potential upside during times of economic growth (equities).