Many new investors (and even experienced investors) believe that investing in bonds is safer than investing in stocks. However, this is not necessarily true, and this broad generalization overlooks the risks associated with investing in bonds.
Bonds vs. Stocks
It may be helpful to refresh your memory about the difference between bonds and stocks. Both carry unique risks, as well as profit opportunities.
Bonds
Bonds are debts that have been converted into securities that can be bought and sold by investors. Companies or government entities issue bonds in exchange for cash, and there are various forms that bonds can take. Interest payments are one way that bondholders can profit from their investment.
Assessing Bond Safety
Entities that issue bonds are rated based on their ability to repay their debts. Companies and entities with a AAA rating are often considered less risky, so AAA-rated bonds may be safer than many stocks. However, bonds rated BBB- or lower are considered “junk bonds,” and they may be riskier than stocks.
Stocks
Stocks are shares of ownership in a company. When you buy a share, you are purchasing a partial stake in the company. While there are many complex ways to trade stocks, basic stockholders can benefit from two ways to profit: the company may issue dividends, or they may sell the share later after the price has increased.
Diversifying a Stock Portfolio with Bonds
Investors may believe that bonds are safer than stocks because they are often advised to add bonds to their portfolio for diversification. Historically, bonds and stocks often move in opposite directions; when stocks rise, bonds fall, and vice versa. These opposing movements make diversification appealing. If your portfolio is entirely made up of stocks, and stocks drop one day, your entire portfolio will decline that day. However, if your portfolio contains half stocks and half bonds, your bond investments may rise while your stock investments fall.
Volatility Isn’t Necessarily Dangerous
Another reason investors may think stocks are safer than bonds is that they can be less volatile than stocks. It’s not unusual for a stock price to rise or fall by 5% in a day, but bonds rarely move that quickly over a short period.
Don’t Forget Inflation
While AAA-rated bonds may provide relatively stable income, when interest rates are low, it can be challenging for that income to keep pace with inflation. From April 2019 to April 2020, prices for all goods, except food and energy, increased by 1.4%. This means that the bond needed to yield at least 1.4% during that time, or you would lose purchasing power. An AAA bond that yields 1% may be “safe” in that the issuer is expected to honor the bond’s terms, but it may not be “safe” concerning the best strategy for building wealth and protecting investments from inflation.
Example
An example may help you understand the concept. Imagine you have a choice between two investments in your portfolio.
The first investment is a corporate bond that pays a 8.5% annual interest. If the company goes bankrupt, this bond is third in line for liquidation preferences. Generally, secured creditors like bank lenders come first in the liquidation preferences, followed by unsecured creditors like bondholders, then preferred stockholders, and finally common stockholders. However, every company is different.
The second investment is common stock in a debt-free company trading at a P/E ratio of 10. About 5% of the earnings are sent to shareholders annually as dividends, resulting in a dividend yield of 5%. Management is good, sales are stable, and the business is slowly growing faster than inflation. If the company goes bankrupt, stockholders are first in the liquidation preferences due to the absence of bondholders or preferred stockholders.
In
This scenario, stocks are likely the safest investment. Here is why.
Stocks have nothing ahead of them
In the example mentioned, stocks are first in the liquidation preference, while bonds are third. Common stocks without anything ahead of them are considered “safe” just like bonds without anything ahead of them – if something happens, they are the first people to receive anything that remains after paying off employees, owners, suppliers, and other prior creditors.
Taxes can affect bond yields
Bonds pay an annual interest rate of 8.5%, but corporate bond yields are usually subject to taxation at local, state, and federal levels. Payments from bonds will be added to your taxable income for the year, so the exact tax rate you’ll pay depends on your income bracket. For high-income earners, this could lead to a significant reduction in the overall yield from bonds.
On the other hand, dividends can be “qualified.” There are exceptions to this rule, but generally speaking, dividends are considered “qualified” if they come from a U.S. company and you’ve held its stock for more than 60 days. Qualified dividends are subject to preferred capital gains tax rates rather than ordinary income tax rates.
Bond terms are definitively fixed
If things go well, it is possible for the company to increase its dividends for stockholders. Stock prices can also rise, allowing you
Source: https://www.thebalancemoney.com/are-bonds-safer-than-stocks-357382
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