Why Are Bonds Considered Lower Risk Than Stocks?
When putting together a portfolio, you may have heard that bonds are less risky than stocks. This is generally considered to be the case. Bonds are more likely to generate a low but reliable return on investment. Stocks, on the other hand, can offer a potentially greater return, but there’s also a greater chance that your investment will lose money.
Let’s take a closer look at bonds and stocks so you can develop a deeper understanding of why bonds are considered lower risk than stocks.
Bonds vs. Stocks: What Are They?
Bonds and stocks are two different types of financial instruments issued by companies.
A bond is a certificate of debt, like an I.O.U note. When you buy a bond from a company, you are effectively lending that company money. On a specified date in the future, known as the maturity date, the company will pay you that money back. In the meantime, the company will pay you interest on the debt it owes you at an agreed-upon interest rate. These fixed interest payments make bonds a predictable investment that can provide fixed income.
If you simply hold a bond until the bond’s maturity date rather than trade it on the bond market, your return will be equal to the interest rate that the bond pays out. If bond prices rise, you may choose to sell the bond, however most bond investments are ideal for generating interest income over time.
A stock is a certificate of ownership in a company. When you own a stock, you own a tiny fraction of a public company. That typically comes with a right to participate in shareholder meetings and vote on board members, as well as a small claim to future profits from the company. These profits may be paid out in the form of a dividend, although not all companies pay dividends to shareholders.
Investing in stocks isn’t inherently risky but stock risks tend to be higher than bond risks. Stock investments tend to be more volatile than bond investments. Whereas bonds are sold at a fixed price with regular interest payments, a stock price will fluctuate daily and may be susceptible to large price fluctuations (especially when the stock market is experiencing higher volatility as a whole).
Types Of Bonds
There are a variety of different types of bonds, each with its own benefits and risks.
Notably, companies aren’t the only entities that issue bonds. Bonds can also be issued by national governments, states, or municipalities. For example, the US government may issue bonds to borrow money to pay for things like trade, war, or Social Security. A local township could issue bonds to raise money for a new school building.
Bonds offer the bond issuers a simple way to borrow money at fixed interest rates.
In general, there are three types of bonds to know about:
- Corporate bonds are issued by companies. Companies often issue bonds rather than go to a bank for money because they can raise more money at lower interest rates.
- Government bonds are issued by the federal or by the government of another country (for example, you can buy government bonds issued by the UK government). Government bonds are commonly referred to as treasury bonds (or “treasuries”).
- Municipal bonds are issued by a local or state government. In some cases, interest payments from municipal bonds can be tax-free.
In general, government bonds and treasury securities are considered extremely safe. The US government has never defaulted on its bonds, and it’s extremely uncommon for the governments of other developed nations to default. However, bonds issued by the governments of developing countries can be notably riskier in that the issuing government might be unable to pay them back.
Municipal bonds also tend to be relatively safe. Most townships and states work hard to keep strong credit ratings, which requires that they pay back their bond debt on time.
Corporate bonds can vary widely in how risky they are. Large and well-known companies like Apple are very likely to pay back their bond debt. Companies with a lot of debt or that are struggling to bring in revenue might be much more likely to default.
Typically, companies’ creditworthiness is rated to give investors a sense of how risky their bonds are. Bonds are assigned a credit rating based on the credit risk of the bond issuer. Bonds whose issuing companies have a credit rating of B or less are considered junk bonds.
Generally, there is a trade-off between credit risk and interest rates. Companies issue bonds because they need to raise money, and the only way they can raise money is if people buy the bonds. If the company is at higher risk, they may need to offer higher interest rates to attract bond investors.
Why Are Bonds Considered Lower Risk Than Stocks?
Bonds are typically considered to be less risky than stocks for several reasons.
The first and most important reason is that bonds pay a fixed rate of return – the interest rate promised to the bondholder. So, you know exactly how much money you can expect for holding a bond regardless of changes in the bond’s market value. Even if interest rates fall, your initial bond interest rates will be guaranteed until the bond’s maturity date.
While some stocks pay a fixed return in the form of a dividend, dividends are never guaranteed and must be approved by a company’s board before every issuance. Many investors rely on dividends for fixed income, however dividends are not guaranteed. Stock prices of dividend stocks may drop below the dividend rate, which poses another risk. For example, a stock may have a 2% dividend yield. If that stock drops 5% in a year, the dividend is eclipsed by the stock price decline.
Another key aspect that makes bonds relatively low risk is that the holder is entitled to get the principle paid for the bond back on the maturity date. Regardless of what the market value of a bond is, it has a defined value if you simply hold it until the maturity date. That’s a big difference from stocks, which don’t have any intrinsic value beyond what other investors are willing to pay for them.
The main risk to holding bonds, of course, is that the company (or government) that issued the bond will declare bankruptcy. In that case, not only will you no longer receive interest payments, but you could lose your entire initial investment since the company won’t be able to pay back the principal. While you cannot avoid risk entirely, you can minimize this risk in bond investing by investing in bonds issued by companies with high credit ratings (and avoiding lower credit rating bonds).
Of course, stocks are not immune to the risk of bankruptcy either. If you’re holding stocks for a company that declares bankruptcy, the stock will become worthless as well.
The important difference here is that bondholders can recover some value. A bankrupt company will sell off assets to pay its debts, and bondholders are first in line for payment. So, you could still get back most of the money you paid for a bond. Stockholders are last in line for payment, and they typically receive very little compensation if any.
Bonds are also considered lower risk than stocks because the bond market has typically been less volatile than the stock market. That is, bond prices have seen smaller swings compared to stock prices. So, even if you have to sell your investments during a market downturn, the magnitude of the downturn will be smaller if you’re invested in bonds as opposed to stocks.
When Are Bonds Riskier Than Stocks?
There are some situations in which bonds can be riskier than stocks. In particular, bonds can be very risky when inflation goes up. That’s because the interest rate on most bonds is fixed. But if inflation rises, a bond may end up paying an interest rate that’s lower than the inflation rate – leaving you with less value than you started with.
The situation for bonds is even worse when interest rates drop. In that case, you have to pay more money for a bond that pays out less in interest.
Which Is Better For You: Bonds Or Stocks?
Whether bonds or stocks are better for you depends on your investing goals and risk tolerance. In the current low-interest rate environment, many investors consider stocks to be a better investment because they offer a much higher rate of return. Many bonds are barely outpacing inflation, so you could end up losing value over time.
However, even when bonds are losing value to inflation, they still offer more certainty than stocks. You may know that a bond will lose, say, 1% per year to inflation, but you don’t know whether a stock will result in a 10% gain over the next year or a 10% loss. If you don’t have the stomach for investing in potentially volatile stocks, then bonds might make sense for your portfolio.
Most long-term investors purchase both stocks and bonds. The combination of both assets makes for a well-diversified portfolio. Many investors will utilize a blend of stocks and bonds that is reflective of their risk tolerance. For example, an investor with a long-term horizon may build a portfolio of 90% stocks and 10% stocks. A risk-averse investor nearing retirement may opt for 60% stocks and 40% bonds.
Stocks and bonds both have a place in a well-balanced portfolio. You just need to choose your blend.
It should also be noted that risk can be mitigated at the asset-level. Risk is endemic to investing and you can find risky investments in both the bond market and stock market. Risk-averse investors can avoid risky bonds and minimize stock market risk by investing in lower-volatility stocks.
Conclusion: Bonds And Stocks
Bonds tend to be considered a lower risk investment than stocks. They offer a fixed rate of return, and you get your entire initial investment back when a bond reaches maturity. Plus, bond holders are first in line to receive compensation in the event that a company defaults and declares bankruptcy.
However, bonds can be riskier in a low interest rate situation like the one the US economy is in right now. That’s because they can fail to keep up with inflation, so you end up losing value over time even as they make interest payments.