Overview – Understanding the Difference Between Stocks and Bonds
Even if you only have an inkling of investing knowledge, you’ve probably heard the words “stocks” and “bonds” before. Many individuals toss these words around freely, without truly understanding what these things are, their major features, and key differences.
Broadly speaking, securities fall into one of three categories: debt instruments, equity securities, and other securities/derivatives.
Bonds are a type of debt instrument, and the term “equities” is usually used to describe stocks (the definition of equity may vary based on the context it is used in).
There are myriad other securities/derivatives in existence, but these financial instruments are usually very exotic and are securities many investors, especially young and/or new investors, will not have in their portfolios.
In this article, we will focus on two security types: stocks and bonds. Their major features will be looked at, while also looking at each of their respective drawbacks.
Another type of security, options, will be talked about briefly near the end, but it will not be an in-depth discussion.
Understanding Stocks – Overview
Stock, commonly referred to as equities, represents an ownership stake in a business. When an investor purchases a company’s stock, they become partial owners of that business.
The terms “stocks” and “shares” are sometimes used interchangeably, but that is incorrect. “Stock” refers to the ownership stake that companies put up for sale to the public. When a company issues stock, what they’re really doing is offering investors the opportunity to become partial owners.
“Shares” are the individual units of ownership that investors purchase.
For example, say you want to invest in Shopify. Shopify offers stock and is traded on the Toronto Stock Exchange under the symbol “SHOP”. You decide to invest, so you purchase 100 shares of Shopify stock. You only purchased one stock, but you purchased 100 shares of that stock.
If an investor says they purchased 100 stocks, then that means they purchased ownership stakes in 100 different companies.
This difference between stock and shares is subtle yet crucial when understanding investing-related discussions.
Stocks generally fall under two major types: preferred and common.
Preferred Stock
Preferred stock can best be thought of as a hybrid between a bond and a common stock (more on both of these shortly).
In the event a company declares bankruptcy and is forced to liquidate its assets, they rank below bonds but are more senior than common stock in terms of who gets compensated first.
Holding preferred shares means the individual holding them has fractional ownership over a company, just like common shareholders. However, there are some differences.
When it comes to dividends, preferred shareholders get priority over common shareholders. The payments received can be either fixed or floating (i.e. it can change) – floating dividends are usually based on an interest rate benchmark, the most common being LIBOR.
Some preferred shares are convertible, meaning that they can be converted into common shares if an investor wants to.
Note that not all preferred shares have the option to convert. Some convertible preferred shares have a set date as to when they’ll be converted, whereas others require approval from the board of directors for the conversion.
There are also preferred shares that are callable, meaning they can be repurchased by the issuing company on a future date.
A key difference between preferred and common stock is that most preferred stock does not confer voting rights to the shareholder.
This means that although preferred shareholders are fractional owners of a company, they have no say when it comes to deciding important corporate policies (e.g. vote to move head office location) or appointing members of the board.
This non-voting feature may be disadvantageous to preferred shareholders because they are essentially at the mercy of common shareholders, who hold the voting power. However, this feature is very favourable for the company because it can raise capital without further diluting control.
A very famous example of this non-voting feature being used to its fullest potential was Microsoft’s purchase of $150 million worth of Apple non-voting preferred shares in August 1997.
Long story short, both companies stood to gain a lot from this transaction, and the non-voting feature of Apple’s preferred stock helped make that happen.
Common Stock
Next, we have common stock. In terms of their claim on assets, they rank the lowest, meaning that in the event a company goes out of business, common shareholders are the last to receive compensation, assuming there are any funds remaining.
Although common stock is last in line when it comes to being compensated, they are at the top of the food chain when it comes to corporate hierarchy.
Unlike preferred shareholders, common shareholders have the right to vote on important corporate matters. Common shareholders hold a lot of power over the company, having the ability to make very drastic corporate changes.
An example of important corporate matters put to a vote was when the shareholders of energy company Ovintiv voted to move corporate head offices from Calgary to Denver in late 2019, citing that the move would put Ovintiv in a better financial position.
The decision was viewed as a major blow to the Canadian oil and gas industry, but this was what shareholders decided was best for the company.
A common shareholder is, legally speaking, at the top of a company’s hierarchy, since they hold the power to appoint the Board of Directors, and in turn, the Board appoints the CEO.
If shareholders feel that a certain Board member isn’t representing their interests to the best of their ability, then this individual will most likely be voted out by shareholders in the near future.
Although common shareholders have the ability to directly impact a company’s operations, they also take on the greatest investment risk. Should the company experience hard times, common shareholders bear the risk of seeing their investment greatly decline in value.
In a worst-case scenario, a company may cease to exist, rendering all outstanding shares void. The market value of all those shares becomes $0.
The Dividend Process: From Declaration to Payment
Although common and preferred shareholders have the right to receive dividends, there’s no guarantee that they’ll always receive them. Remember, creditors outrank shareholders when it comes to who gets compensated first.
Having the right to dividends means shareholders can make a request for dividends to be paid, but they are not entitled to receive them. The decision to pay dividends rests with the Board of Directors.
Receiving dividend payments may sound like companies can pay them to shareholders on a whim, but that is not the case. Every company must go through a set procedure before dividends are received by shareholders.
Dividends can be paid in cash or in shares, but cash payments are by far the most common.
The dividend process is shown in the image below. We will go over the details of each stage individually.
1.) Declaration Date: this is the date a company announces the size of the dividend (i.e., how much money investors will receive per share), the ex-dividend date, and the date of record. This usually takes place a few weeks before the dividend is paid.
2.) Ex-Dividend Date: the ex-dividend date marks the day where, if investors were to purchase shares on this day, they will not qualify for the upcoming dividend.
Investors must purchase shares before this date to receive the dividend; similarly, shareholders who wish to sell their shares but want to receive a final dividend payment must sell on or after this date.
The ex-dividend date is one business day prior to the date of record.
3.) Date of Record: the date of record is when a company identifies all current shareholders, and therefore who is eligible to receive the dividend.
This may sound redundant because of the cut-off the ex-dividend presents, but that is not the case.
Just because an individual purchases shares does not mean the transaction has been settled. An individual can purchase and receive shares on the same day, but they will not show up in company records as a shareholder that same day.
This process of appearing, or being removed, from a company’s records is called the settlement date, which occurs two business days after the trade.
If an individual purchases shares on Friday, they will appear in the company’s records on Tuesday. Therefore, an individual who purchases shares on the ex-dividend day will not receive dividends because the trade will be settled one day after the date of record.
4.) Distribution Date: this is the day investors receive their dividend payments.
Understanding Bonds
Bonds are called debt instruments because they are simply just portions of a debt being sold to the public.
Imagine a company has a debt of $10,000; they can break up this debt into ten, $1,000 portions then sell those portions to the public as marketable securities. Bonds can be issued by corporations and all levels of government (federal, state/provincial, and municipal).
A bond is essentially a contract between two parties: the issuer and the buyer.
The agreement is that the buyer agrees to lend money to the issuer to repay a portion of their outstanding debt. In return, the issuer agrees to pay the buyer back their initial outlay of money (i.e., their principal) after a set amount of time, in addition to paying them intermittent interest (coupon) payments.
For example, imagine an investor buys a 5-year bond for $1,000 which offers semi-annual interest payments, with an interest (coupon) rate of 5%.
The bond issuer receives $1,000 to repay their debt, while the buyer receives a $50 interest payment twice a year for the next five years. After the five years have passed, the issuer is required to repay the $1,000 they initially received.
This contractual structure of a bond may imply that bondholders will always receive their initial outlay and coupon payments, but that is not the case.
Contracts can, and sometimes are, broken. There is no guarantee that the bond issuer will repay the buyer. A bond’s security is only as good as the issuer’s ability to satisfy the conditions of the bond.
Generally speaking, the amount of interest paid and an issuer’s creditworthiness is inversely related. That is, the more questionable an issuer’s ability to meet their obligations, the higher the interest (coupon) rate of the bond.
This is to provide an incentive for individuals to purchase bonds from less attractive issuers. For example, a bond being issued by a third-world country’s government has a very high likelihood of default, so the government must incentivize investors in some way to purchase their debt – this is accomplished by offering outsized bond yields.
Because a bond represents a contract, bondholders bear zero operating risk. It doesn’t matter if a company experiences a steep decline or if a government struggles to bring in revenue, bondholders have a contractual claim to receive a certain amount of compensation.
However, bondholders cannot enjoy any future success that the issuer enjoys, such as a stellar fiscal year for a company or an increase in tax revenue.
Shareholders are likely to be rewarded with increased dividends and significant capital appreciation, but bondholders are only going to receive the set interest payments and the money they initially spent.
Bond prices do fluctuate, but they are sensitive to interest rates, not corporate developments or day-to-day market sentiments.
In the event of a liquidation (i.e. a company is forced to sell assets to repay creditors and other relevant parties), bondholders are first in line when it comes to their claim on assets.
Other Securities: Options
This article has focused on stocks and bonds because these are the two asset classes new and young investors will likely hold in their portfolios (it would be very unusual for a new investor to have a multi-million dollar portfolio comprised of exotic financial instruments).
However, it’s important to know that there are other security classes beyond stocks and bonds, which investors could one day hold in their portfolios. Options are one such example.
Options are derivatives, meaning they extract their value from an underlying asset. In other words, a derivative is only as valuable as the asset it’s backed by.
Options are a contract that gives buyers the right, but not the obligation, to buy or sell the underlying asset by a specific date (called the “expiration date”) and at a specific price (called the “strike price”).
For example, imagine the stock of company ABC is currently selling at $100. An investor purchases an options contract on April 1, 2020, that allows them to purchase 100 shares of ABC for $70. The investor can avail of this option up until December 1, 2020. They’re not required to exercise their option, but their ability to do so is valid until December 1.
Types of Options
Generally speaking, there are two types of options: calls and puts.
Call Options: calls grant the option holder the right, but not the obligation, to purchase the underlying asset at the specified strike price.
Usually, investors buy call options when they believe the underlying asset will increase in value or sell their options when the asset is expected to decrease in value.
Put Options: puts give option holders the right, but not the obligation, to sell the underlying asset at the specified strike price. The options writer (i.e. the one selling the option) is obligated to buy the asset if the option is exercised.
Usually, investors buy put options when they believe the asset value will decrease and sell if they believe the asset value will increase.
Options can further be categorized as “US-style” or “European-style”.
US-Style: option holder can exercise their right at any moment during the exercise period.
European-style: the option holder can only exercise their right on the expiration date.
Wrapping Up
The figure below provides a brief summary of all the securities we’ve looked at:
Each security we’ve looked at has its place in an investor’s portfolio, so it’s in every investor’s best interest to understand what each security entails.
Whether you decide to hold equities, bonds, or options in your portfolio, it would be wise to understand what each security does and how exactly they contribute to reaching your investment goals.
