What's the Difference Between Investing in the Bonds (or Debt) Versus the Shares (or Equity) of a Company?
You might think that it doesn't make much difference whether you invest in a company's shares or its bonds. After all it's the same company paying you in either case. So surely it just depends on how well that company does. Of course it does depend on the company's performance. But don't be fooled. Investing in corporate bonds and shares give very different investment risks and returns, even if it is in the same company.
The Difference in a Nutshell
The difference between shares and bonds is this:
- Shareholders own the company. That's why shareholders are sometimes described as owning equity in the company, and so shares are sometimes known as equities.
- Bondholders loan money to the company.
This fundamental difference explains all the differences I will go into in this article, so keep it in mind as you read on.
What do Bondholders and Shareholders Get?
Bondholders are owed money by the company. So they are paid interest on the loan at regular intervals (called coupon payments) and then they get the loaned money (the principal) back at the end of the agreed loan period (the term of the bond). See here for more about corporate bond terms and definitions.
Shareholders own the company. They can expect to make money from their ownership in a couple of ways. They can expect to get paid a share of the profits after any costs (including the cost of paying bondholders). This payments to shareholders from company profits are called dividends. Shareholders may also be able to sell their shares at a profit if the share price has done up. See here for more about share (or equity) terms and definitions.
Risks of Bonds and Shares
This basic difference also means that bondholders and shareholders have different risks, even when they have invested in the same company.
The big risk for a corporate bond investor is that the issuer defaults; in other words he can't or won't pay the interest on the bond and/or pay the initial loan back at the agreed time.
The big risk for a shareholder is that the company goes bankrupt and their investment is worthless.
If the company is bankrupt, creditors like bondholders will be paid before any left over money is paid to the shareholders. So if anything goes wrong the bond holders are more likely to get their money back than shareholders.
Also bondholder's interest payments are fixed and will be paid unless the company defaults (which most companies will desperately try to avoid). Dividends paid to shareholders are not (usually) agreed in advance and can reduced or even not paid at all if the company is struggling.
On the other hand bond payments might have their value eroded by inflation, whereas company profits and so dividends at least have the chance of going up with inflation
But remember there is an advantage to diversifying your investments between different kinds of investment assets.
Returns From Bonds and Shares
As a general rule higher investment risks are rewarded with higher investment returns. Since bondholders get their money back before shareholders do if it all goes wrong, it's not surprising to learn that most of the time long term returns are higher for shares than bonds in the same company.
If the company does not default then a bondholders returns are fixed. The interest payments are agreed and won't change.
A shareholder on the other hand will get either dividends (which are decided in the future by the company and not agreed in advance) or could sell their share for a capital gain if the price has gone up. (Have a look at this article about the difference between income and capital gains.) This means that the return to shareholders is not guaranteed and could be lower or higher than expected. It also means there is no limit to how much the money the shareholder could make - if the share price rockets up their returns could be enormous.
Corporate bonds and shares offer different risks and rewards and both could be the right choice for you depending on your situation. Understanding what exactly you are investing in and how it works will give you the best chance of finding investments that are suitable for you.
As with any investment always do your research before investing and be very cautious with money you can't afford to lose. Good luck and happy investing.