Stocks and Bonds, combined together, could be one of the most important yet confusing decisions facing you as an investor.
First, it is important to get a basic understanding of stocks and bonds.
Stocks ideally provide long-term growth potential and the role of bonds is to provide an income stream.
Buying part ownership in a corporation
When an investor buys shares of stock, he or she buys part ownership in a corporation. The value of the corporation’s stock depends on the corporation’s earnings. Usually, the higher the return, the higher the risk.
Blue chip vs. small capitalization (Small Cap)
“Blue chip” stocks: Issued by companies that are well established within their respective industries and have long histories of producing earnings and paying dividends.
Small capitalization, or “small cap,” stocks: Shares in companies that are less established. They have growth potential, which could mean a large return, but the risk is higher.
Bonds: Making a loan to a corporation
Bonds represent loans made by investors to companies and other entities, such as branches of government, that have issued the bonds to attract capital without giving up managing control. A bondholder, in effect, holds an IOU.
Bondholders do not share in a company’s profits. They get a fixed return on their investment. This return, stated as an interest rate on the bond, is called the “coupon rate” and is a percentage of the bond’s original offering price.
Bonds are issued for specified time periods. When the bond expires and the principal (original investment) is returned, the bond is said to have MATURED.
Bonds can take AS LONG AS 30 YEARS to mature.
Time to maturity and the issuer’s ability to make good on its payment obligations are the two most important factors in choosing individual bonds to purchase.
Bond Risks: Every bond carries the RISK that a promised payment will NOT BE MADE IN FULL OR PAID ON TIME.
**As uncertainty of repayment rises, investors demand higher levels of return in exchange for assuming greater risk.
Potential bond buyers can assess an issuer’s ability to meet its debt obligations by considering the bond rating assigned by agencies such as Moody’s Investors Service or Standard & Poor’s. A rating indicating a high likelihood of repayment will allow an issuer to sell its bonds with a lower coupon rate than one that received a poorer rating.
Bonds, similar to common stocks, fluctuate in market value and, if sold prior to maturity, may produce a gain or a loss in principal value.
Government vs. corporate bonds
U.S. government and U.S. government agency bonds are considered the safest bond investments. They are not insured but are backed by the “full faith and credit” of the U.S. government with respect to both principal and interest. Also available are mortgage-backed securities, which in many cases are fully backed by a U.S. government agency.
Corporate bonds are generally issued by industrial corporations, financial firms, public utilities, and transportation companies. They usually pay more interest than government bonds but carry a greater risk of default. If a corporation goes bankrupt, bondholders have priority claim, before stockholders, on the company’s assets.
Choosing the right option
Stocks have an unlimited ability for appreciation. It is true that a bond can sell at a premium prior to maturity, but the potential for appreciation here is nowhere near as great as it is for stocks.
Both options have their risks as well. Stocks can drop in value and become worthless. With bonds, there is interest rate, inflation and credit risk. Credit risk is the risk that the bond issuer will be unable to make its payments on time or at all, effectively defaulting on the bonds.
Diversity May Minimize Risk
Ultimately, spreading your investment funds among various classes of stocks and bonds is a safe choice. A mix of stable, fixed-income investments (to help cushion stock market volatility) and stocks (to provide growth potential over the long haul) is a key ingredient to working toward meeting long-term financial goals.