Investors typically have an inclination to buy either stocks or bonds, but rarely make a choice between the two. After finding a company that looks like a good investment candidate and getting to know the business and the financials, investors should make a choice about which type of investment to make. Stocks are investments in which the investor takes an ownership interest in the corporation. Bonds allow investors to lend money to the corporation and receive interest. Let’s take a look at how these very different investments are affected by corporate events.
Stocks
Stockholders own a share of the company in which they are invested. Stocks are traded on an exchange and prices are set by the market. Stock prices are typically driven by financial results, company news and industry fundamentals. They are usually valued on a “multiple” basis. Stock investors generally invest in companies that they feel have superior growth prospects and are undervalued by the market. While the market sets the prices and no one shareholder should be able to influence prices, stockholders have a way of influencing management and company decisions via proxy voting. Stockholders only receive “payment” for their investment when the stock price increases or dividends are paid.
Bonds
Bondholders differ from stockholders because they do not have any ownership stake in the company. Instead, bondholders essentially lend a corporation money under a set of rules/objectives (covenants) the company needs to follow to maintain good standing with the bondholder. Once the bond matures, bondholders receive the principal investment back from the company. In the meantime, they receive coupon, or interest, payments on the bond (usually semiannually).
Bonds are traded in the bond market and prices are set by the market based on the financial fundamentals of the company issuing the bonds (most notably the strength of a company’s balance sheet and the ability of the company to pay its obligations). Bonds have an inverse price and yield relationship, such that bonds sell at a premium when they are less risky (meaning the coupon is low) and at a discount when the risk is higher. The principal does not deviate and is therefore called the face value, but the coupon and price do change based on perceived financial strength and investors expectations about the company.
Bonds are rated by rating agencies (Standard & Poor’s, Moody’s, Fitch) based on their characteristics. When any of these agencies changes its rating, market prices fluctuate. Therefore, bonds are also subject to market speculation of rating changes. Investment grade bonds are generally considered safe from financial failure, while high-yield bonds are much riskier.
Stock or Bond Investment?
Companies face many decisions that affect investors. One of the greatest conflicts between investors and companies is that what is good for one stakeholder may not be good for the other. Let’s take a look at some situations that may benefit or hurt stock and bondholders’ positions.
Situation 1: A Company Borrows Money to Expand When a company borrows money, stockholders’ earnings per share (EPS) is negatively affected by the interest the company will have to pay on the borrowed funds. However, borrowed funds do not dilute stockholders’ holdings by increasing shares outstanding and may benefit from increased sales revenue from the expansion. Bondholders, on the other hand, may face a decline in the value of their investment as the company’s perceived risk increases as a result of its increased debt load. Risk increases, in part, because the debt could make it harder for the company to pay its obligation to bondholders. Therefore, under a typical scenario, stock prices will be less affected than bonds when a company borrows money.
Situation 2: A Company Buys Back Stocks When a company announces a stock buyback, stockholders are generally pleased by this announcement. That is because stock buybacks reduce shares outstanding so the profit is spread among fewer shares resulting in higher EPS for each share and, in general, a higher stock price. On the other hand, bondholders are usually not happy with this type of announcement as it cuts the company’s cash on hand and reduces the attractiveness of the balance sheet. Therefore, under a typical scenario, stock prices will generally react more positively than bond prices.
Situation 3: A Company Files For Bankruptcy When a company files for bankruptcy, the stock usually falls precipitously. The company’s bonds are also faced with a sell-off, although the degree to which this occurs depends on the situation. The difference in the degree of negative reaction between stocks and bonds is that stockholders are the lowest priority in the list of stakeholders in a company. Bondholders have a higher priority and, depending on the class of bond investment (secured to junior subordinated), receive a higher percentage of invested funds. Therefore in this situation, bond prices will typically hold up better than stock prices.
Situation 4: A Company Increases Its Dividend When a company increases its dividend, stockholders receive a higher payout. Bonds, on the other hand, face pressure as the company reduces its cash on hand because this could interfere with its ability to pay bondholders. As a result, stocks generally react favorably to this announcement while bonds may react negatively.
Situation 5: A Company Increases Its Credit Line When a company increases its credit line, stocks are generally unaffected. At best, stocks may react positively because the company will not try to issue new shares and dilute current shareholders. Bonds, however, may react negatively because it could be a sign that a company is increasing its borrowed funds. However, if there is a cash squeeze in the short term, it may mean the company can meet short-term obligations, which is positive for the bondholders.
Conclusion
Any potential investment should be based on a company’s fundamentals while considering the potential likelihood of various situations or scenarios that may impact the investor. After finding a company that meets your investing criteria, a decision on whether to invest in the bond or stock needs to be made. Continually reviewing the investment in light of changes based on company decisions is a necessary component of any investment strategy.
