Introduction
The question of whether bonds provide a lower risk investment than shares is one that cannot be answered directly. One must consider the external environment (investment cycle), with regard to interest rates and inflation, the internal environment of the concerned corporation, and the goals of the investor.
An analysis of the two investments
Bonds may be defined as fixed amounts of money lent to issuers who commit to pay investors a fixed interest payments as well as initial capital at the end of the investment term. Therefore, one acts as a creditor to the institution and is not party to the ups and downs of the issuer’s business outcomes (Cummins 2008). Conversely, a share is a financial instrument in which an investor purchases part of a company. In other words, shares enable a person to become part owner of the business. This implies that the investor’s returns are affected by how well the market evaluates a company’s worth. At face value, stocks are highly volatile because shareholders have no guarantee of investment returns. When a firm goes through a loss, shareholders would be the first to the bear the brunt. As part owners, they are expected to share in losses and profits of an institution. Further still, if the bank went bankrupt, then the first people to loose out would be stockholders. Creditors have a higher priority and could get some reprieve. On the other hand, if an investor bought bonds from a certain company, then he or she would still get his interest payments and final returns regardless of how poorly or well the company performed (Fulton 2005). In unfavourable market conditions, bonds are safer. However, during market booms, then shares are more rewarding. Investors interested in minimising risk would be better off with bonds but those who want maximum returns for their investment, would prefer stocks.
An inverse relationship exists between bonds and interest rates. If interest rates increase, this leads to a decrease in the value of a bond. If the type of bond purchased is long term, then this decrease will even be more dramatic. On the flipside, a decrease in interest rates signifies an increase in the value of bonds. Therefore, investors who have bonds with short term maturities will benefit (Knight & Cavaglieri 2013). Take the example of an investor who took a bond that pays an interest of 5%. If interest rates increase to 6.5%, then new investors will find bonds which pay out much higher interest rates at similar or lower prices. The person who had a bond portfolio with a 5% rate of return would seem less attractive to buyers. If one has to sell their bond, they would have to do it at a lower price than what they had paid for it. In essence, the value of their portfolio will go down.
The biggest concern for most investors in the bonds market is whether interest rates will increase. Conversely, stock market investors are deeply concerned about a fall in market prices. When the dreaded situation arises in either portfolio, bond market investors are susceptible to less risk than stock owners. In the bonds market, interest rates can increase but when they do, the coupon payments or interest payments made increase as well. It should be noted that bond holders often receive interest payments on their investment biannually and expect a return of the initial capital plus an interest payment upon maturity of their portfolio. Therefore, as interest rates increase, bond holders can obtain high interest payments and use the returns to reinvest in their bond funds (Corkery 2013). Therefore, this worst-case scenario does not spell doom for an investor as he or she will still get payment; the only difference is that it will amount to a low level of return for short-term portfolios. Long term bond investors can even gain from such fluctuations. On the flipside, if stock prices fall, then the effect is more dramatic and dire for share owners. No hedge exists for shares during a stock market crush and they will essentially loose their investment. This exposure of stock owners to market forces is what makes many analysts describe them as high-risk.
The above comparison does not in any way imply that bonds have no risks. Certain situations may arise that could substantially increase a bond portfolio’s risk. First, an investor ought to consider the financial capability of the issuer. These capabilities are assessed through their credit ratings. If an investor buys bonds from a high-risk issuer, then the investor may have to face the possibility of default or delayed payment (Arjun et. al. 2012). On the other hand, some people are not afraid of risk and may still purchase bonds from institutions will low credit ratings in order to attract high interest payments. As a rule of thumb, firms with low credit ratings pay high premiums because they need to attract clients to their investment portfolio (Eom et. al. 2004). They would be non competitive if no such offer existed. Therefore, in such circumstances, bond funds would contain high risks. On the flipside, certain types of bonds have much lower risk than shares could ever offer. These include government bonds or gilts. The latter are sometimes called risk free because the government has the capacity to manipulate monetary policy in order to meet its bond commitments. For instance, it could increase taxes or increase currency availability in order to pay bond funds. Therefore, government bonds are relatively lower in risk. Charles (2013) makes an even more pessimistic assertion by explaining that investors in crowded bonds markets may fail to get buyers when their investments reach maturity.
Even the relative risk rates for shares vary from stock to stock. Some companies, known as blue-chip firms, have been in business for long and have established a reputation for continually paying out dividends. If one were to purchase shares from such companies, then one would be purchasing relatively low risk investments. On the other hand, a person can buy shares from relatively unknown companies with low capitalisation but high potential for growth. In this regard, the investment would be relatively high-risk (Das et. al. 2008). In just the same way that a bond can be altered to become high-risk, it is also possible to choose stocks in a manner that makes them low risk.
Additionally, the time frame within which one wants to make an investment has a dramatic effect on the performance of the investment. Generally, stocks are a better investment than shares in the long term. This implies that if one has many years before retirement, then they ought to consider shares (Swanson 2010). High growth potential occurs in shares because they allow one to correct for market fluctuations. Bonds always remain relatively stable, so they do not yield the best value for money invested.
The diagram below is an illustration of dollar growth rates between 1959 and 2008 in the US market for a $1 investment in bonds and shares correspondingly.
Inflation rate also has a substantial effect on one’s rate of return in shares and bonds markets. Inflation is a measure of the purchasing power of a currency unit. If inflation rate is high, then chances are one’s investment returns would be low. Bonds that reach maturity during a high-inflation period will pay out much less than they were worth initially (Bessembinder et. al. 2006). Conversely, certain types of stocks have a sort of hedge that is built into them. If one buys shares from a blue chip company, which consistently pays out dividends, then chances are that one will be protected against inflation. With regard to this parameter (inflation rate), it would be wiser to go for high quality stocks than bonds.
Recommended investment at this time in the investment cycle
At the moment, interest rates are low; as stated earlier, an inverse relationship exists between bond value and interest rates, for that reason, it would be wise to purchase bonds now as they seem to possess less risk in the short term (Wall 2012). Since no one knows how long this long-risk situation will last, then one would be better off purchasing a short-term bond portfolio rather than a long term one (McGee 2012),. Nowadays, some institutions even offer maturity periods that are as low as three years, so it would be prudent to select such a time frame.
It would also be a good idea to purchase bonds if one is looking to safeguard their initial investment. In fact capital preservation is one of the qualities that attract many investors to the bonds market (Glowrey 2012). Regardless of how slow one’s growth will be, an investor is always guaranteed their initial investment. Therefore, risk-averse individuals will be comfortable in such scenarios. Stock prices are currently not stable, especially given the 2008 global downturn (Roth 2012). It is always a good idea to focus on bonds whenever the stock market seems too volatile. Bonds and shares always operate in a mutually exclusive fashion. If stock prices are up, then bonds will go down. Currently, stock prices are not up so it would be better to invest in bonds. Furthermore, the government has lowered interest rates in order to stimulate the economy; this means that interest payments will be high for bond holders in the short term. To minimise a lack of buyers during the expiry of the bond, as predicted by Charles (2013), investors should focus on gilts. The government has control over liquidity so buyers will be shielded.
If one is looking to invest for the long term, it would be favourable to consider the stock market. The expression ‘long –term” could mean periods of 20 to 30 years. The investment would cushion one against potential market shocks as corrections will occur within the period (Frey & Bytes 2012). Additionally, it would yield high returns as seen through the graph above. Although stocks possess significant risk, this risk would be worth taking if they are hedged out over a long period of time. Positive real returns make the latter investment wise over the long term. Shares will provide the growing income stream that makes them highly attractive over time.
Conclusion
When investors have a short-term goal, they should consider bonds as equities would have too much risk. If they want a long term investment, they should consider shares. On the other hand, if one wants to build a portfolio, then one can balance their long term and short-term needs of the markets by combining bonds and shares.
References
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Bessembinder, H, Maxwell, W, and Venkataraman, K 2006, ‘Market Transparency, Liquidity Externalities and Institutional Trading Costs in Corporate Bonds’, Journal of Financial Economics, vol. 82, no. 2, pp. 251-288.
Charles, J 2013, ‘Called to Account: Bonds to tie up and strangle your savings’, The Sunday Times, 10 February 2013, p.19.
Corkery, M 2013, ‘Making bonds act like stocks’, Wall Street Journal, 22 January 2013, p. C1.
Cummins, D 2008, ‘CAT bonds and other risk-linked securities: State of the market and recent developments’, Risk Management and Insurance Review, vol. 11 no.1, pp. 23-47.
Das, S, Freed, L, Geng, G and Kapadia, N 2012, ‘Correlated Default Risk’, The Journal of Fixed Income, vol. 16 no. 2, pp. 7-32.
Eom, Y, Helwege, J & Huang, J 2004, ‘Structural models of corporate bond pricing: An empirical analysis’, Review of Financial Studies, vol. 17 no. 2, pp. 499-544.
Frey, A & Bytes, I 2012, A beginners guide to investing: How to grow your money the smart and easy way, Create Space Independent Publishing Firm, Chicago.
Fulton, G 2005, Bonds – The other market, Authorhouse, London.
Glowrey, M 2012, The Sterling bonds and fixed income handbook, Hargreaves, London.
Knight, J & Cavaglieri, C 2013 ‘Cash or bonds or shares – what’s best for this year’s ISAs?’ The Independent.
McGee, S 2012, ‘Buy stocks or bonds? Yes’, The Wall Street Journal, 2013, p. R8
Roth, M 2012, Finding the top stocks: Strategies for success top stocks 2012, Wright books, New York.
Swanson, M 2010, Strategic stock trading, Create Space Independent Publishing Firm, Chicago.
Wall, E 2012, ‘Should investors switch from bonds to shares?’ The Telegraph, 2012, p. 15.