- Date : 13/04/2021
- Read: 5 mins
Your purpose and risk appetite should determine your investment behaviour. Two market instruments that are often clubbed together can, in reality, display contrasting performances.
As a lay investor who has always been advised to diversify their portfolio, you must have adequate information about different market instruments. Two investment options that are often clubbed together – bonds and stocks – have a stark difference in nature. From risk to returns, both work towards helping an investor grow money, but differently. Let’s take a closer look at the difference between bonds and stocks, and see whether bonds are a safer instrument to invest in.
Bonds vs stocks
Bonds and stocks are two ways for investors to grow money or expand business operations. While bonds represent debt, stocks signify partial ownership (or, as investors call it, equity). When you are issued a bond, it is on the agreement that interest will be paid for the money. Stocks, on the other hand, are shares of companies that are sold to individuals in exchange for cash. They represent partial ownership or equity in the firm because you purchase a part of the business. The more stock you buy, the more stake you have in the company. Over time, as the company grows, so does the value of its stocks. But if the business runs into loss, the value of your stock falls, and eventually, if you sell those stocks, you lose money.
Related: Dummy’s guide to investing in government bonds or G-Secs
Debt vs ownership
Since buying bonds is inferred as a debt that must be repaid with interest, you will have no equity or ownership in the company. However, since it is an instrument of money growth, you will be entering into an agreement with the issuer of the bond for a fixed interest income. Over time, you will earn a fixed interest and the principal amount invested at the end of the tenure.
Fixed income vs capital gain
Stocks fall in the riskier end of the investment spectrum because of their volatility. When you purchase stocks, you should take into consideration the possibility of both gains and losses. If you sell the company shares at a higher price than you bought, you generate a capital gain when held for more than a year. This income can be reinvested but it is taxable. Bonds, a slightly safer investment option, generate regular payments and are less affected by market volatility.
Diversify stock portfolio
In a generic market scenario, bonds go down when stocks go up, and vice versa. So while the common notion of bonds being safe than stocks is not entirely true, it does make diversification a safe cushion. If your portfolio consists of only stocks if it tanks you can lose all your money. The strategy of diversification with bonds will position your money better in case of unexpected market dips.
While volatility does not necessarily make bonds a risky investment, it sure is less nerve-wracking to watch out for market speculations. On any given day stock prices can fall or rise drastically by up to 5%, but bonds rarely move this way in such a short duration. Bonds are safer because they are less volatile and have lesser unknown market factors in play. Bondholders have complete knowledge of how much and when they will receive interest payouts.
Types of bonds
Being a high-security debt instrument, bonds come in different types. Here are some of the most widely preferred bonds available in the market:
- Fixed interest bond: When buying a fixed interest bond, investors know what they are signing up for. These bonds are the safest investment option for those looking to make a regular income. The predetermined rates remain unaffected by market conditions and investors know their gains beforehand.
- Floating interest bond: Floating interest bonds are susceptible to market volatility. These bonds are an interesting investment option when you want to maintain a portfolio return that is in sync with the inflation rate.
- Government securities bond: This debt instrument is issued by the state/central government only when it is facing a crisis and requires funds. Ranging from a tenure of 5 to 40 years, these bonds also known as SDLs (state development loans). They can be either fixed or floating.
- Convertible bond: Offering the best of both worlds, convertible bonds represent a hybrid feature of debt and equity, but not in a single time frame. It allows investors to convert bonds into regular stocks to become a stakeholder in the company along with equity benefits.
- Inflation-linked bond: Issued primarily by the Government of India, inflation-linked bonds provide a cover against inflation risk.
- Sovereign gold bond: SGBs are issued by the Government of India for investors looking to invest in gold but do not want to physically keep it with them. One of the most secured investment options, interest earned from SGBs is tax-free.
To conclude, bonds are a safer investment than stocks because they allow investors to earn a stable income indexed by market fluctuations. In the meantime, look at these common stock trading mistakes you should avoid.