CHOOSING the right mix of equities (stocks) and bonds can be one of the most basic yet confusing decisions facing any investor. In general, the role of equities is to provide long-term growth potential and the role of bonds is to provide an income stream. The question is how these qualities fit into your investment strategy.
Equities: buying part ownership in a corporation
When an investor buys shares of stock, he or she buys part ownership in a corporation. As such, the value of that corporation’s stock will tend to reflect the earnings experience of the firm – up during profitable periods and down during periods of loss. Generally speaking, the higher the potential return, the higher the risk. For example, stock investors expect a fairly high rate of return because there is no schedule of repayment and no stated rate of return like that paid by fixed-income securities such as bonds.
Blue chip vs small cap
Even within the world of equities, there are variations in risk and reward. “Blue-chip” equities are issues of companies that are well established within their respective industries and have long histories of providing investors with a means to manage risk and solid, though not spectacular, growth.
Small capitalisation, or “small cap” equities represent shares in companies that are less established or are simply smaller companies. Because of this, they have the potential for tremendous growth, which can translate into a large return for investors. Coupled with this, however, is a higher likelihood of decrease in their value than you would expect from well-established companies. In this respect even small companies are substantial, often with a market capitalisation of 500 million pounds sterling.
Bonds: making a loan to a corporation
Bonds represent loans made by investors to companies and other entities, such as branches of government, that have issued the bonds to attract capital without giving up managing control. A bondholder, in effect, holds an I.O.U.
Bondholders do not share in a company’s profits. Rather, they are promised a fixed return on their investment. This return is called the “coupon rate” and is a percentage of the par value, which is the bond’s original offering price.
Bonds are issued for specified time periods. When the bond expires and the capital (original investment) is returned, the bond is said to have matured. Bonds can take as long as 30 years to mature. Time to maturity and the issuer’s ability to make good on its payment obligations are the two most important factors in determining a bond’s coupon rate.
Every bond carries the risk that a promised payment will not be made in full or on time. As uncertainty of repayment rises, investors demand higher levels of return in exchange for assuming greater risk.
Potential bond buyers can assess an issuer’s ability to meet its debt obligations by considering the bond rating assigned by agencies such as Moody’s Investors Service or Standard & Poor’s Corporation. A rating indicating a high likelihood of repayment will allow an issuer to sell its bonds with a lower coupon rate than one that received a poorer rating.
Bonds, similar to common equities, fluctuate in market value and, if sold prior to maturity, may produce a gain or a loss. Such fluctuations are fully reflected in the daily changes in the unit value of each bond fund.
Government vs corporate bonds
US and UK government bonds are considered the safest bond investments. They are not insured but are backed by the “full faith and credit” of the government with respect to both capital and interest.
Corporate bonds are generally issued by industrial corporations, financial firms, public utilities, and transportation companies. They usually pay more interest than government bonds but carry a greater risk of default. If a corporation goes bankrupt, bondholders have prior claim, before stockholders, on the company’s assets.
Choosing the right option
An important distinction when weighing the rewards of equities vs bonds is that equities have (theoretically) an unlimited ability for appreciation. That is, there is no upper limit to how valuable they can become.
On the other hand, a bond buyer generally knows the upper limit to expect on such an investment, especially if it is held to maturity. It is true that a bond can sell at a premium prior to maturity, but the potential for appreciation here is nowhere near as great as it is for equities.
If you have a long time before retirement, equities appear to have substantial advantages because there is more time for the market to correct any downturn that may cause a decrease in value of the stock. However, concentrating too heavily on equities – at any age – can mean missing the significant benefits bonds may offer. Should bonds be part of your portfolio now? Perhaps. Nearly every investor has some financial needs that bonds could potentially fill.
If you need a shorter-term strategy, you might do better to consider bonds. They are useful tools in their ability to hedge against market fluctuations and the normal ups and downs of the economy.
Spreading your investment funds among various classes of equities and bonds – diversifying – is the choice for many. A mix of stable, fixed-income investments (to help cushion stock market volatility) and equities (to provide growth potential over the long haul) is a key ingredient to working toward meeting long-term financial goals.
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