Bonds Vs. Stocks – Forbes Advisor UK

Capital at risk. All investments carry a varying degree of risk and it’s important you understand the nature of these. The value of your investments can go down as well as up and you may get back less than you put in. Where we promote an affiliate partner that provides investment products, our promotion is limited to that of their listed stocks & shares investment platform. We do not promote or encourage any other products such as contract for difference, spread betting or forex. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK. Accurate at the point of publication.

Investing involves putting money into a range of so-called ‘asset classes’. Stocks and bonds are two of the most common asset classes, and both can play an important role within an investment portfolio.

But how much an investor allocates to each depends on individual investment goals, time horizons, and risk tolerance.

Understanding the fundamentals behind stocks and bonds, as well as how they differ, can help investors make the best financial planning decisions for their needs.

What are stocks?

An investor who owns stocks (or ‘equities’ or ‘shares’) is generally referred to as a ‘shareholder’. Shareholders are entitled to receive any dividend payments that a company might make. They also have the right to vote on decisions relating to the business, such as how much the executive board is paid, or whether the company should go ahead with a merger, acquisition, or takeover.

Where are stocks traded?

Stocks/shares in publicly-listed (rather than privately-owned) companies are bought and sold on a stock exchange such as the London Stock Exchange.

There are various ways for a company to ‘go public’, or to ‘float’. The most common is for the company to hold an initial public offering or IPO.

An IPO provides a company with a way to raise money by selling shares in its business. The number of shares issued, multiplied by the price for which they sell, determines a company’s value. This is known as its market capitalisation, or ‘market cap’.

Why do companies list on the stock market?

There are several reasons why a company decides to join the stock market. The main aim is to attract capital from investors. Other reasons include boosting the profile of its business and increasing its credibility with customers and prospective investors.

A flotation also provides a way for a company’s founders and staff to profit by selling some of their shareholdings to new shareholders. 

Having floated successfully, a company may follow up with extra share issues when it needs more cash to support future growth ambitions.

A private company neither offers not trades its shares to the general public on the stock market. Its shares are held by private individuals, employees, or large-scale investors such as private equity firms.

How are stocks and shares categorised?

Stocks are allocated to industrial sectors to make it easier for an investor to weigh up different investment opportunities, or focus on a particular part of the market, for example, energy or technology.

The UK stock market is open for trading from 8am until 4.30pm, Monday to Friday. During this period, the prices of quoted companies will move up and down according to demand and depending on how the market views their prospects.

Several factors affect a company’s share price movements – from the publication of its results to wider economic and geo-political events, such as inflation or interest rate figures, or international conflict and its subsequent impact on key markets such as energy and food.

Why would one own stocks?

Having exposure to equities provides company shareholders with a direct link to the business and its performance.

Share prices tend to rise when companies are judged by the market to be performing well. But when a company is thought to be doing badly, or its prospects are regarded as taking a turn for the worse, the share price can move downwards.

The volatile nature of equity investing means, therefore, that it is not suitable for everyone.

No one can predict the future. But, historically, owning shares has outstripped the returns available from cash deposits over the long term. Equity investing has therefore been one of the few asset classes providing a ‘real’ return after the effects of inflation have been taken into account.

How do you invest in stocks and shares?

There are two main ways to invest in the stock market: either by buying shares in a company directly, or investing indirectly via various options including investment funds, index tracking or exchange-traded funds, and investment trusts.

Members of the public, often referred to as retail investors, can buy investments such as these via products known as general investment accounts offered by numerous online trading platforms.

It is also possible to hold these investment in tax-efficient ‘wrappers’ such as individual savings accounts and self-invested personal pensions.

What are bonds?

Bonds are loans issued by governments and companies usually for a fixed time period, with interest paid in the form of a ‘coupon’. 

Bonds with a shelf life up to three years are categorised as either ‘ultra-short-term’ or ‘short-term’, between three and 10 years ‘medium-term’, while ‘long-term’ bonds can run for several decades.

When they are first issued, bonds are made available to investors on the ‘primary market’. After they have been issued, they can be traded in the same way as shares on the ‘secondary market’, where their prices fluctuate according to supply and demand.

Key terms in the bond market include:

• Issuer: a government or company looking to borrow money by issuing a bond
• Par: relates to the bond’s face value. Usually priced in increments of £100 or £1,000, it is the amount of money that is repaid once the bond had matured
• Market value: a bond’s current trading price
• Coupon: the interest rate (also known as ‘nominal yield’) paid by the bond as a percentage of the par value. Payments are usually made to bondholders once or twice a year
• Maturity: relates to the bond’s ‘redemption date’ when the original loan is repaid
• Risk: relates to the likelihood of the bond’s issuer defaulting on repayments. The higher the coupon, the riskier the bond is likely to be. Agencies such as Moody’s provide risk ratings for bonds starting with the lowest risk ranked AAA, followed by AA, A, BBB, etc.

What are the different types of bonds?

• Government bonds: in the UK these are known as ‘gilts’ (‘Treasuries’ in the US). Most of the 95 gilts currently in issue in the UK have a fixed coupon. But about a third are index-linked, which means their coupon rises in line with inflation
• Corporate bonds: issued by companies and other institutions. Risk-ratings are sub-divided into investment grade bonds and riskier, speculative grade bonds (also known as ‘high yield’ debt). Given their higher risk status, speculative grade bonds pay a higher coupon than investment grade bonds to compensate investors for the higher risk of default.

How do bonds work?

The coupon and face value of bonds only form one part of the return. Once bonds start trading on secondary markets, their prices rise and fall in the same way as shares according to supply and demand. As a result, bonds can trade at a premium or discount to their face value.

For example, say the 4% Treasury Gilt 2060 from above, with a par value of £100 and a coupon of 4%, was available to buy at £94 on the secondary market. This would represent a 6% discount to its face value.

However, an investor who managed to buy the gilt for this price would still receive annual interest of £4. This means the effective annual return from the bond would work out higher than the 4% coupon because the bond cost less than its original £100 face value.

What affects the price of bonds?

Interest rates and the cost of borrowing are the key factors that influence the price of bonds on the secondary market. In simple terms, if prevailing rates rise above a bond’s coupon, then the bond becomes less attractive because investors can seek out higher interest rates elsewhere for less risk. This reduces demand for a bond and so its price will fall.

As a result, inflation can also have a marked effect on the price of bonds. When inflationis high, as has been the experience of major economies the world over in recent years, central banks hike interest rates to bring inflation back to long-term target levels, and doing this has a detrimental effect on bond prices.

In addition to prevailing economic conditions, three other factors can affect bond prices:

• Credit ratings: a downgrade in a bond’s credit rating will lessen demand due to the higher risk of default
• Market conditions: demand for ‘defensive’ assets such as bonds tend to rise during stock market downturns
• Time till maturity: as bonds approach their redemption date, their prices usually move to around par, the amount that bondholders will receive when the bond comes to the end of its life.

Advantages of bonds

• Predictable income stream: bonds pay a stable income stream until maturity, whereas dividend payments from shares are not guaranteed and can be liable to change. In this sense, bonds can be helpful to investors, such as those in retirement, looking for a reliable income stream
• Return of capital: bondholders receive the face value of the bond at maturity. Depending at what point the bond was bought, the repayment could be higher or lower than the purchase price
• Diversification: for a portfolio already made up of cash, shares and property, bonds can further help to diversify a portfolio
• Lower risk: neither the UK nor the US government has ever defaulted on a bond payment, helping make bonds a lower risk option to equities.

Disadvantage of investing in bonds

• Interest rate risk: rises in borrowing costs tend to have a negative effect on bond prices
• Risk of default: despite the blemish-free record of the UK and US, two-thirds of governments worldwide have defaulted on their bond obligations since 1960, according to the Bank of England and Bank of Canada
• Liquidity issues: bonds issued by smaller or higher risk institutions or companies may be harder to trade because of a smaller pool of potential buyers.

How do you buy bonds?

Gilts can be bought directly from the UK’s Debt Management Office. Bonds can also be bought via online stockbroking and trading platforms.

Another option is to invest in bonds indirectly through specialist investment funds. You can find out more about these funds with our in-depth guides picking the best bond funds and best bond ETFs.

What’s a better investment choice – stocks or bonds?

Knowing the difference between stocks and bonds helps investors decide which investment type is best for them and their financial goals. It may be that a combination of stocks and bonds strikes the right note.

Generally speaking, bonds tend to be more appropriate for investors with a conservative outlook and nearing or at retirement age. With the right selections, they can provide steady, reliable income and feature depressed levels of risk.

Investors with more appetite for risk may find that shares-based investments are a better option. Investing in shares can offer more potential for growth, providing an individual is able to weather market fluctuations that inevitably occur.