Stocks vs corporate bonds

When it comes to investing, stocks and shares get much more column inches than corporate bonds. Rightly so in my opinion, since over longer time periods stocks have outperformed corporate bonds.

As we’ll see below, there are good reasons to expect that outperformance to continue. Yet almost every book on asset allocation will tell you to diversify your portfolio into corporate bonds.

To decide if that’s right for you, it’s important you understand the following about stocks vs corporate bonds.

These are fundamental differences between the two asset classes that cannot be ignored.

Stocks vs corporate bonds: Properties and performance

In comparing stocks vs corporate bonds, we’re asking two questions:

• How do stocks and corporate bonds differ as investments?
• Which asset class will likely make me the most money?

Entire books have been written to try and answer both questions, but I’ll attempt it in two articles!

Below we’ll see how stocks and corporate bonds differ. In part two, we’ll consider the past returns of stocks versus corporate bonds.

(Don’t know anything about corporate bonds? You’ll want to read the rest of my corporate bond series before rejoining us here!)

Owners (stocks) Vs lenders (bonds)

When you invest in stocks or corporate bonds, your money is used to fund the operations of companies.

The difference is what you get in return for your investment.

When you invest with a stock, you become a part-owner in that company. When you invest with a corporate bond, you become a creditor, and the company owes you fixed interest payments on your money, plus its eventual repayment.

As a part-owner of a company, via stock, nothing is guaranteed

You may expect to receive a growing dividend stream from your investment, and you’ll hope the stock price will rise over time.

But dividends depend on management discretion and company profits. As for the stock price, as we saw in the 2008 bear market, share prices can go anywhere over the short to medium term, regardless of the company’s performance.

As a bondholder, you expect fixed interest and your money back

We saw previously in this series how owning a corporate bond entitles you to interest payments, plus the repayment of the face value of the bond when it matures.

Bondholders also stand higher up the pecking order if a company goes bankrupt. These attributes theoretically make corporate bonds less risky than stocks, so you’d expect the returns to be lower, which they generally are.

Is it better to be a lender or an owner?

Reading through the differences above, a reasonable answer might be ‘lender’.

After all, your income and your investment is more secure with corporate bonds than with stocks.

Even if you believe stocks will deliver better returns over the long-term, you might prefer the more stable returns from investing in company debt via corporate bonds.

However, it’s important to realize that being a bondholder inherently caps your returns, compared to owning stock in the same company.

• Your returns are fixed with bonds, dependent on the price you pay. You may expect to see a capital gain on maturity if you buy the bond at a depressed price, but the most you will get is the face value of the bond on maturity, plus the annual interest while you hold it.

• Companies take on debt to invest in the business at a profit. If a company will pay you 5% a year  via a corporate bond, that’s because it expects to make say 10-15% by reinvesting your money in its business. As a shareholder and owner, you benefit from the returns generated by the bondholders’ money. As the Oblivious Investor explains in this lengthy post, an individual company may screw up its plans, but in aggregate companies won’t borrow at an interest rate greater than their internal rate of return.

• You can lose 100% of your money with both stocks and corporate bonds. But stocks can also double, triple or ‘Do A Microsoft’ and go up a hundredfold. Investment grade corporate bonds are much less likely to lose all their value than stocks, but their capped returns also mean they’ve far less scope as a class to make up for individual losses with big gains elsewhere.

These differences all result from the different characteristics of being a shareholder/owner, versus being a bondholder/creditor.

There are also subtler return-damaging aspects to corporate bonds:

• The risks are skewed against bond investors. In his excellent book Unconventional Success (here’s the US link) the Yale University investment manager David Swensen argues that corporate bonds offer neither the diversification benefits of government bonds, nor the superior returns of equities. He also spells out why corporate bondholders tend to see poorer returns over time due to the skewed characteristics of their investment.

• Companies often issue ‘callable’ corporate bonds, for instance, so that if interest rates fall they can refinance their debt at a cheaper rate. But bondholders can’t do the same if interest rates rise and the attractiveness of their bond diminishes.

• Ratings downgrades are another asymmetrical feature. If an investment grade corporate bond is AAA-rated by the agencies, the only way it can go is down, which will cause its value to drop. Sure, you can buy junk bonds and hope for an upgrade but that’s a very different business to investing in secure bonds for income and security.

• Management is more aligned with the interests of shareholders than bondholders. Swensen argues this in great detail, but the takeaway is that due to how debt affects a company’s balance sheet and the fact directors’ personal wealth is usually linked to the company’s share price, either via direct holdings, options or performance targets, a company’s management will tend to try to improve the share price at the expense of bondholders. (Another example would be a leveraged buyout, where lots of debt is taken on to fuel a takeover. The company is now more risky, so its debt will be downgraded, yet the share price will almost certainly have soared due to a bidding war).

• It’s harder to value bonds than shares. Very few people realize this, and indeed equity analysts get paid more than bond analysts in The City. Yet to invest in a single bond, you really need to know how likely it is the company will be able to meet its interest payments, and what you’ll get back if it goes bankrupt. This entails understanding the company’s business – just like an equity analyst – as well as all the additional complications of bond investing. Corporate bonds are not the simple investments they appear to be.

As I’ll explain later in this series, the best way to invest in corporate bonds is through an ETF or a fund, so you spread your risk (just like with shares).

This doesn’t mean these factors aren’t relevant to you, though. You may not be evaluating individual bonds, for example, but if you invest in a managed bond fund you’re certainly paying someone to do so!

The next part of this series will look at the expected return of stocks vs corporate bonds, so please do subscribe to ensure you get the lowdown.

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Other kinds of bonds you may come acrossHistorical returns from corporate bonds