Many new investors (and even experienced investors) often make the mistake of repeating the old saying that "investing in bonds is always safer than investing in stocks." It isn't necessarily true, and this overly broad statement glosses over the risks that come with bond investing.
While some bonds may be a safer investment than many stocks, there are a lot of variables that could affect the relative risks of the two securities. When investing in any type of security, it's important to consider the unique risks of the investment, the price of the investment, and the broader market conditions.
Here are a few of the primary reasons why bonds can be—but aren't always—safer than stocks.
Bonds vs. Stocks
It may be helpful to refresh yourself on the difference between bonds and stocks. They both carry unique risks, as well as the opportunity for gains.
Bonds are debt that has been turned into a security that can be bought and sold by investors. A company or government entity issues bonds in exchange for cash, and it promises to repay the bondholder. The repayment schedule will include interest payments, and those payments are one way that bondholders can profit from their investment.
A bondholder can also profit by selling the bond, but they can also lose money this way. The price of the bond depends on demand. If investors are eager for a steady stream of income (in the form of interest payments) then the prices of bonds rise. When stock prices are rapidly rising, investors are less likely to settle for the meager returns of interest payments, so the prices of bonds fall and companies have to offer higher yields to entice investors to buy their bonds. Investors who actively trade bonds or invest in bond funds (with fund managers that trade bonds) expose themselves to these risks of price movement, as well as risks related to interest rate movement.
If an investor buys a new bond and holds it to maturity, then they will get all their money back plus interest. However, bonds are a form of debt, and like any debt they come with the risk of default. If you buy a bond from a company, and then that company goes bankrupt, you could lose your money. Bondholders get paid out before common stockholders during the bankruptcy process, but they aren't necessarily first in line for payments, and they may not receive any money at all. The order of payouts in cases of corporate bankruptcy is known as the "liquidation preference."
Bond Ratings Determine Safety
Stocks are shares of ownership in a company. When buying a stock, you're buying partial ownership in the company. While there are many complex methods of trading stocks, basic buy-and-hold stockholders can profit in two ways: the company can issue dividends, or they can sell the stock at a later date after the price has increased.
Both of those methods of profit come with some risk, but the level of risk depends on the company behind the stock. A company doesn't have an obligation to issue a dividend, so there's the risk that the company could decide to stop issuing dividends if their financial situation has worsened since the last dividend payment. Stock prices are based on demand for the stock, so if demand for the stock plummets, then the stock price will fall, as well. While it's normal for stock prices to fluctuate, the price is unlikely to crash unless the company is facing serious hardship.
Bonds Can Diversify a Stock Portfolio
Investors may believe bonds are safer than stocks because they're often told to add bonds to their portfolio for the sake of diversity. Bonds and stocks have historically moved in opposite directions; when stocks go up, bonds go down, and vice versa. This isn't an absolute truth that you'll see followed every day, but generally speaking, you can expect to see bonds rise on a day when stocks tank.
These opposite movements make diversification appealing. If your portfolio is entirely made up of stocks, and stocks decline on a day, your entire portfolio will decline that day. However, if your portfolio is half stocks and half bonds, then your bond investments may rise while your stock investments fall.
This doesn't make bonds a safer investment than stocks. Rather, the strategy of diversification makes your portfolio safer. Some days, stocks will fall and bonds will rise. Other days, stocks will rise and bonds will fall. A well-diversified portfolio is better positioned to weather any dips in any particular sector.
Volatility Isn't Necessarily Dangerous
Another reason investors may believe stocks are safer than bonds is because they are less volatile than stocks. It isn't all that unusual for a stock price to rise or fall by 5% on a given day, but bonds hardly ever move so drastically in such a short amount of time.
That's because stock prices are speculative, so there are a lot of unknowns. With bonds, there are far fewer unknowns. As long as the bond issuer doesn't default, the bondholder knows exactly when they'll receive interest payments, and they know exactly what those payments will be.
The lifetime of the bond can also impact its volatility. Long-term bonds are more likely to experience volatility—more can happen between now and the maturity date.
However, volatility doesn't necessarily make a stock more dangerous than a bond. Stocks have always had peaks and troughs throughout the year, and some companies fold, but historically, major market indexes have always regained their ground and continued to grow. It may be more nerve-wracking for a stockholder to check their account on a day-to-day basis, but over a long enough timeline and with proper diversification, the stockholder isn't necessarily less likely to experience gains.
Don't Forget About Inflation
AAA bonds may offer a relatively safe assurance of steady income, but when interest rates are low, that income could struggle to keep up with inflation. From April 2019 to April 2020, prices for all items aside from food and energy rose by 1.4%. That means a bond held during that time would have needed to yield at least 1.4%, or else you would effectively lose buying power. A AAA bond yielding 1% may be "safe," in the sense that the issuer will likely honor the terms of the bond, but it may not be "safe" when it comes to the best strategy for building wealth and protecting against inflation.
An example may help you understand the concept. Imagine you have a choice between two investments for your portfolio.
The first is a corporate bond that pays 8.5% interest annually. If the company goes bankrupt, this particular bond is third in line for liquidation preference. As a general rule, secured creditors like bank lenders come first in liquidation preference, then unsecured creditors like bondholders, then preferred stockholders, then common stockholders. However, each company is different.
While bondholders usually receive liquidation payments before stockholders, most investors should try to avoid investing in entities that are likely to declare bankruptcy.
The second investment is common stock in a debt-free company that trades at a P/E ratio of 10. Approximately 5% of the profits are mailed to stockholders each year as dividends, resulting in a dividend yield of 5%. Management is good, sales are stable, and business is growing slightly faster than inflation. If the company goes under, the stockholders are the first in line in liquidation preference since there are no bondholders or preferred stockholders.
In this scenario, the stock is likely the safer investment. Surprised? Here's why.
The Stock Has Nothing in Front of It
The stock example is first in line in terms of the liquidation preference, while the bond example is third in line. Common stock with nothing ahead is just as "safe" as a bond with nothing ahead of it—if something goes wrong, they are the first people in line to receive anything left after the employees, landlords, vendors, and other prior creditors have been paid.
Taxes Could Take a Bite out of the Bond Yield
The bonds pay interest of 8.5% annually, but the yields from corporate bonds are usually taxable at local, state, and federal levels. Payments from the bond will be added to your taxable income for the year, so the exact tax rate you'll pay depends on your income bracket. For top earners, this could result in a serious dent in your overall yield from the bond.
Dividends, on the other hand, can be "qualified." There are exceptions to the rule, but in general, dividends are considered qualified if they come from a U.S. company whose stock you've owned for more than 60 days. Qualified dividends are subject to more favorable capital gains tax rates, rather than ordinary income tax rates.
The Terms of the Bond Are Set in Stone
It is possible, if things go well, for a company to increase its dividend payouts to stockholders. The price of the stock could also rise, allowing the stockholder to cash in on the appreciation. With a bond, you get the bond coupon rate, and that is it. If the company that issued the bond suddenly experiences massive success, it won't change the terms of the bond to be more favorable to bondholders. Neither will the terms of the bond change related to inflation rates. Inflation could rise, but you'll still only receive the 8.5% you were promised when the bond was issued.