Financial Literacy Friday: Stocks vs. Bonds
Today I wanted to switch up my focus a little and talk about some of the basics of the financial world in what I’m calling Financial Literacy Friday. This will be an ongoing feature on Friday’s as I go over and explain various terms and concepts within finance. Many people work in specialized fields and don’t usually have the time to learn about the financial world and receive little to no education on the matter from school. So today we’re going to be focusing on stocks and bonds, with the main difference being that stocks signify ownership in a corporation and bonds are a debt obligation in which you loan an entity money in order to get repaid at a later date plus interest.
So, I’ve mentioned that stock signifies ownership in a company, but let’s break down what that entails. By buying stock in a company, you have a claim on the assets and earnings of that company proportional to how much stock you own. This is determined by the amount of outstanding stock that the company creates, so if the company has 1,000 shares of outstanding stock and you own 100 shares, you would have claim to 10% of that company’s assets. There are two types of stock as well, common and preferred, so let’s go over each type.
Common stock entitles the holder to receive dividends and most importantly vote at shareholders meetings.
Preferred stock generally does not entitle the holder to voting rights, but has a higher claim on assets and earnings than common stock. This means that if the company disburses dividends, it will go to preferred stockholders before those who own common stock. The same is true if the company were to go bankrupt, preferred holders are of a higher priority if the company is liquidated.
Bonds are one of the other major generic asset classes (the three being stocks, bonds, and cash equivalents) and are used by companies and governments to raise money without obtaining a loan from a bank. If you buy a bond, you become a debtholder or creditor to whichever company or government entity issued the bond, which is quite different than owning stock. When a bond is issued, it contractually states the interest rate to be paid and the duration of the bond, or when the principal amount is to be repaid.
For example, if you bought a bond with a 10 year maturity and an interest rate of 5% for $1,000, you would receive $50/year for 10 years until the bond is repaid. One interesting aspect of bonds is that because the interest rate is contractual, the attractiveness of buying bonds differs with what the economic interest rate is. An example of this is if you bought the above bond with a 5% interest rate, and the interest rates dropped to 4%, that bond would still be paying 5% interest thereby increasing its attractiveness to investors. The same is true if the interest rates go up to 6%, the bond would still pay out 5% and be less attractive, which is why bond prices move inversely with interest rates. These interest rates are determined by two factors, the duration of the bond (how long it lasts) and the credit quality of the issuer.
I also wanted to briefly touch on the three major types of bonds before I wrap up, so here they are.
Corporate bonds are issued by companies
Municipal bonds are issued by states and municipalities and can be tax free for residents of those municipalities
U.S. Treasury bonds which have more than 10 years until maturity, Notes which have 1-10 year maturities, and Bills which have less than 1 year maturities. These are collectively known as Treasuries.
This should give you an overview of how a stock operates and how a bond operates, and the differences between the two. I know it can be a bit dry, but hopefully you were able to learn something you may not have known before reading this, and if you still have questions leave me a comment or contact me.