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Introduction to Bonds

Terminology

Bond

A bond is a contract between a corporation (or government agency) and an investor where the investor loans the corporation (or government agency) a certain amount of money for which the investor receives an agreed upon interest payment.

Dividends

A cash payment made to investors who own the dividend paying stock. The dividend is the stock holder's share of the company's profit.

Stock

The term Stock refers to the share ownership of a company that is listed on a stock exchange.

Bonds vs. Stocks

Each have their own benefits and risks

Investing in Bonds for Beginners - Bonds vs. Stocks; Picture of a bond investor and a stock investor sitting on a park bench with each reading a newspaper that looks like money.

The long-term total return from stocks significantly outperforms that obtained from bonds. In the short-term stocks are considerably more volatile than bonds.

Bonds and stocks have different characteristics for both yield and capital gains.

Yield

With bonds, the yield is a fixed amount based on the price paid for the bond (excluding inflation adjusted bonds).

The interest amount paid is the same year after year and is known in advance. These payments will continue as long as the bond issuer is able and willing to finance its payment obligations.

For stocks that pay a dividend, the yield is similarly based on the amount paid for the stock, however the yield is not known in advance as the dividend payment is not known until a dividend is declared.

These dividends typically vary depending on the company's financial position and there is no guarantee that a dividend will be continuously paid into the future. In general, the dividends increase over the long-term in line with growth in the company's profits.

For stocks that do not pay a dividend, there is no yield as there is no income the investor receives.

Thus, for bonds the yield is fixed and known in advance, whereas for stocks that pay dividends, the yield is variable but generally increases over the long term.

Capital gains

Stocks exhibit capital growth over the long-term in line with the growth in the company's profits and its assets. This means that the value of companies in 30 years time is more than it is today.

Bonds do not exhibit a true capital gain as occurs with stocks.

This is because there is no capital growth in a loan (which is what a bond is). The exception is inflation adjusted treasury bonds where there is at least the growth from inflation.

So for a typical 30 year bond, the face value remains static. This means that in 30 years time the investor merely receives back the original face value.

Therefore the total return from a 30 year bond held for 30 years is simply the interest rate yield (since there is no capital gain).

The capital gains from bonds works

differently to that of stocks

While holding a bond from issue date to maturity provides zero capital gain, the value of bonds are very sensitive to the current interest rate environment.

This means that during the life of a bond, its value varies.

This variation in value fluctuates along with the interest rate cycle.

This is not a capital growth as such, since the interest rates themselves only cycle between high and low rather than continuously head in one direction.

These cycles do however provide investors with times where buying bonds will be more profitable.

Buying a bond when its value is less than its face value will actually provide a capital gain on the investors purchase even though the face value has not changed.

A newly issued bond held till maturity does not have any capital growth as it is merely a loan, but savvy bond investors can use bond strategies that provide some capital gain - such as purchasing bonds for less than their face value.

This potential capital gain is quite limited, but it is generally low risk.

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