Living Economics

Bonds vs Stocks
Bonds and stocks are alternative means of business financing where bonds offer steady income while stocks offer potentially substantial capital gains to investors.

Bonds offer a fixed annual coupon which stays constant while the prices of the bonds may deviate from their issue face values depending on supply and demand. When the price of an already issued bond goes down because of excessive selling, the yield of the bond goes up. The yield is simply the coupon divided by the current price of the bond.

If the bond is held to maturity, there will not be any capital loss as the same amount invested at the issue date is redeemed. But if the bond is sold in the secondary market when the market price is lower than the issue price, there will be a capital loss.

Conversely, there may be a capital gain if the market price is higher than the issue price. And the yield of the bond goes down when the fixed coupon is divided by the higher market price of the bond.

Thus the yield of an existing bond moves in opposite direction to the market price of the bond.

When the market price of already issued bonds goes down and the corresponding yield goes up, the coupon rate of new bonds must match the market yield to be competitive. If there is excessive borrowing, the prices of similar bonds would be driven down (and the yield up) forcing the bond issuers to offer higher matching coupon rates.

Bonds are preferred by investors who are attracted by stable coupon incomes and less worried about capital gains or losses. In other words, bonds offer income safety in investment.

On the other hand, stocks do not carry coupons although some stocks do offer pretty stable dividends. Investors who are attracted by possible capital gains prefer the upside potential of rising stock prices. During economic booms, the magnitude of capital gains in stocks is intoxicating unmatched by stodgy bonds. To match the capital gains of stocks, the prices of bonds must be driven down to increase their yield. So the prices of stocks and the prices of bonds tend to go in opposite directions.

During economic recessions when the prices of stocks tank, the specter of huge capital losses induces a flight to the income safety of bonds. The sudden swell of demand for bonds thus drives up bond prices and lowers their yields. For example, the stock market crash in 2008 has led to frantic flight to short-term bonds with almost negative yield just to prevent further capital losses. The yield on the 3-month Treasury note fell to near zero.

Bonds and stocks are alternative means of business financing.

Bonds are debts owed by business firms to bond holders who are creditors to the firms. Firms might prefer bond financing because the coupon interests payable to bond holders are tax deductible. But the coupons are still a drain on the firms’ bottom line and must be paid until the bonds mature or unless bankruptcy is declared. Even under bankruptcy, bond holders still have priority claims over any residual assets.

The coupon rates of new debts depend on the credit worthiness of the borrowers. This credit worthiness is determined by rating agencies such as Standard & Poor. The highest rating is AAA. Bonds carrying any rating below BBB- are considered to be junks. Junk bonds must offer much higher coupon rates and therefore a.k.a. high-yield bonds.

Even the highest rated corporate bonds must carry higher coupon rates than first-class government bonds. The spread between the coupon rates between these 2 classes of bond is known as investment grade spread. During boom times when the chance of bond default is lower, the spread narrows as investors are more tolerant of risk. During recessions, the spread could widen dramatically. For example, in the great recession starting in 2008, spreads on US investment grade corporate bonds over Treasuries widened in late 2008 to 620 basis points (6.2 percentage points) while those on high yield bonds have reached 1950 basis points (19.5%). According to Moody’s, BAA spreads are at their highest levels since the Great Depression. A large spread is needed to compensate for the higher implied default rate.

Stock holders, on the other hand, are part owners of the firms. When businesses are flourishing, the upside of rising stock prices often exceeds the coupon yield of bonds. But if stocks tank and businesses fail, stocks are worthless and the whole investment is so much capital loss. Selling stocks (i.e., equity financing) is an inexpensive way to fund a business by offering ownership without any coupon commitment. There is no obligation for firms to pay any dividend. But if stocks are languishing, firms must offer more shares to get the same amount of financing from new investors.

References:
  • PAM Global Investment. Investment Grade Bonds Offer Good Value. Investment Note - 21 November 2008.
  • WSJ. “Dow declines 427.47; year's drop near 40%. Investors fled to the safety of Treasury securities. The yield on the 3-month note fell to near zero.” 11/20/2008 : Page No. C1
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