Defined Contribution Pensions

Differences Between Bonds and Equities

In summary, equity holders and bond (or fixed interest) holders take on different risks. A fixed interest holder has lent the company money, and is expecting a stream of income or interest payments. These interest payments are subject to changes in interest rates, and the capital value of the bond is subject to the market's perception of the company's ability to pay the interest and the capital. Consequently a bond's price is often close to its nominal value. You will rarely find a bond selling at two times its nominal value.

Equity holders, on the other hand are taking a stake in a company and the value of this stake is often dependent upon the profits that the company makes. So if the company is seen or perceived to be making more profit, then the share price will tend to rise. Hence, the future earnings of the company will often have a direct impact on a profitable company's share price. Equity investors actually base the price of the equities they own on the cumulative future earnings of the company.

Although equity holders are taking on greater risk, they can potentially get a greater profit when earnings rise. The value of the company's stock actually increases with earnings, since the cumulative earnings that a company can expect to receive for the next couple of years is higher. In addition, equity holders may also receive dividends if the company is performing well. What if the company's projected earnings come down? This will affect equity owners directly but not necessarily the bondholder. As long as the company is still capable of financing its debt, the bondholder is indifferent to the fact that earnings have come down.

For bondholders, when earnings take an upturn, the coupon and the principal amount to be paid to investors upon maturity remains the same. This actually means that bondholders are missing out on the capital gains and dividend payout that come with holding equities.

This goes to the root of why the value of equities will be so much more volatile than the value of bonds. As a company may go from making a loss in one year, to making a huge profit in the next, its stock price will go through large swings. That's because equity holders are constantly reassessing the value of the stock based on what they can now expect it to be worth in relation to its future earnings. Whereas for bondholders, the returns they can receive from the bonds are already fixed. Their primary concern is whether the company can repay all its loan obligations. As such, variations in corporate earnings have a much smaller impact, unless the company's fundamentals fail to such an extent that its ability to repay its loans becomes uncertain.

An easy way to see this would be to use an actual example. If a company earns 100 million every year, and uses 10% of that to pay the interest on its bonds, what happens if its earnings drop to 50 million? In such a situation, it is still able to repay its interest comfortably. Furthermore, if the company has £1 billion worth of assets such as land, etc, then bond holders have a claim to those assets, should the company default. This helps to reduce the bondholders' risk. But to a stock investor of that same company, a drop of 50% in that company's earnings is likely to be very bad news. This directly affects the value of the stock. Hence, the stock price may fall sharply.