Investing Basics: Bonds vs Equities

Bond markets were traditionally the preserve of large institutional investors – pension funds, insurance companies and wealth managers purchasing huge chunks of sovereign and corporate debt to deliver predictable long term income to their portfolios – writes Christian Leeming

Individual investors now have access to fixed income markets and with guaranteed income and capital protection, bonds may play an increasing role in the DIY investor’s portfolio in the future.

When comparing the risks of bond and equity investing, bonds appear to offer a clear advantage.

The quality of the credit offered by Gilts is considered superior to that of a bank deposit so the risk of default can be assumed to be zero.

‘credit offered by Gilts is considered superior to that of a bank deposit’

Most bonds are ‘senior’ debt and bonds issued by banks are therefore almost as safe as Gilts – probably carrying the same risk as that of a cash deposit within that bank.

Corporate bonds may carry more risk, but in the event the company were to go into liquidation bond holders are paid out ahead of shareholders.

In terms of market risk, fixed income products again have the edge.

In order to extract a profit from an equity the investor must sell it back to the market – at the prevailing market price; the value of an equity investment is subject to the market demand for that stock and if you need to cash out at a particular time and the market has not been kind, the equity investor could be crystallising a hefty loss.

However, with most bonds, the redemption date and amount are agreed when the loan is made, thereby reducing the dependence on market sentiment or liquidity.

‘bonds holders are paid out ahead of shareholders’

Bonds allow investors to tie money up for a set period of time, knowing the interest payments they will receive along the way, and that their money will be returned in full at a time they may have set to coincide with one of their key financial objectives such as tuition fees or retirement.

Investors not planning or unable to hold the products until maturity will see prices in the secondary market fluctuate due to future interest rate expectations and the perceived credit quality of the issuer; this could either be to the holder’s benefit or detriment.

Long dated bonds exhibit greater price volatility than short dated issues which mellow as redemption approaches and the price returns to par.

Who doesn’t dream of identifying that ten-bagger, and if they get it right, equity investors can see almost limitless returns that would not be possible if they had invested in bonds in the same company.

However, get it wrong, and an equity investor could lose some, or all of their investment; because bonds are issued as senior debt, holders generally receive some or even all of their money back in the event of liquidation.

Bond investors can limit their risk still further by building a diversified portfolio of investment grade products where defaults are very rare.

Bonds prices are generally less volatile than equities although an additional ‘risk’ comes from what could be considered one of bonds’ key assets – guaranteed coupon payments are welcome as long as they outstrip inflation but over longer periods of time inflation can erode the return of a bond portfolio causing its value to fall in real terms.