What's the Difference Between Bonds and Stocks?

Upbeat music plays throughout.

Narrator: The words stocks and bonds are commonly mentioned in the same breath, but they're very different investments.

To understand their differences, let's start with simple definitions.

A stock is a partial ownership of a company. It's considered an "own" investment, so when an investor purchases stock, they're actually buying a piece of the company.

On-screen text: Disclosure: Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.

Narrator: A bond is a loan investment, which means an investor is actually loaning money to an entity, like a company, government, or municipality.

To put it another way, when an investor buys a bond, they're loaning money to a company in exchange for regular interest payments. When they buy a stock, they're buying a small piece of a company.

Animation: Daily news article says "XYZ stock beats estimates" and "XYZ stock product release flops."

Narrator: Both assets can be bought and sold on their respective markets, and the prices can fluctuate—sometimes wildly. This can happen for a variety of reasons, like a particularly good earnings report or a new product release that turned out to be a flop.

Because bonds are a loan, they can be a little more complex than stocks. Whenever a loan is made, certain terms have to be established. The same is true with bonds.

When a company raises money through a bond, it's called a new issue. In a new issue, millions of dollars of bonds are commonly available. The issuer determines a value of the bond, also known as the par value.

Because bonds can be traded throughout their lifetime, they may trade at a premium or a discount in relation to this par value. Like the names suggest, premium bonds are bonds trading at a higher value than their par value, and discount bonds are trading below their par value.

Like most loans, borrowers must pay interest on what they're borrowing. With bonds, this interest rate is called a coupon. For example, a new bond may pay a coupon of $50 per year.

Because coupons are typically paid twice per year, an investor would expect $25 every six months.

On-screen text: Disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.

Narrator: So, a bond that has a coupon of $50 and a face value of $1,000 has a coupon rate of 5%. This is the interest on the loan.

The loan agreement ends when the bond reaches maturity. Maturity is the length of time on the loan and is also the point at which your invested principal is returned to you.

Bond maturities typically range anywhere from one to 30 years. Bonds with maturities less than a year are usually referred to as commercial paper or bills.

Bonds with maturities of one to 10 years are sometimes referred to as notes.

And bonds of 10 to 30 years are simply bonds.

Despite having a maturity of up to 30 years, some bonds can be paid off early. These are known as callable bonds. When this happens, the bond issuer returns the invested principal early. The investor would keep any interest paid to that point, but the early repayment would end any future coupon payments.

So, let's review.

When an investor purchases a bond, they're actually loaning money to an entity like a company.

In return for the loan, the company will pay the investor interest, usually on a semiannual basis.

The interest provides regular and consistent income for the investor until maturity, which may be anywhere from one to 30 years, depending on the bond purchased.

Both stocks and bonds have risks associated with them, like price declines, which can result in losses, and inflation, which can eat into your returns.

Bonds also face some unique risks, like credit risk. This is the risk that an issuer defaults on coupon payments or fails to repay the principal at maturity. This could cause the price of the bond to plummet and significantly reduce your returns, potentially all the way to zero.

Animation: A bond with different credit ratings, such as AA and A. Another example shows the bond credit rating dropping to a B, and the value of the bond decreasing.

Narrator: Bond ratings can help investors determine the likelihood of this happening, but ratings can change.

Another risk of investing in bonds is interest rate risk. If interest rates rise, the value of your bonds will decrease. This typically only matters to traders who want to sell bonds though. If you plan to hold your bonds until maturity, this won't impact the principal you receive when your bond matures.

At maturity, the investor receives their initial investment, or principal, back.

Keep in mind, not all bonds are the same. Some come as secured or unsecured, providing varying degrees of protection. Some carry different interest rate structures and offer various repayment schedules. Investors should keep these factors in mind before investing.

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