According to the Office of Financial Readiness, stocks and bonds are some of the more common investing terms describing the heart of securities markets around the world. Shares of stock represent an equity interest in a corporation, while bonds are debt securities that corporations and governments use to borrow money.
Most other securities are “derivatives,” whose value depends on another (underlying) security or item of value (for example, stock options and warrants, futures contracts for stocks and commodities, and currency trading contracts).
Mutual funds usually invest in stocks, bonds or short-term (money market) bonds, so they are great for diversification. Investors choose stocks as investments to grow their portfolios, and sometimes for income and relatively high liquidity. Also, bonds are attractive as income-producing investments.
So, having a basic definition of stocks and bonds will help you create a list of investment opportunities to better plan your long-term investment planning.
Stocks and Bonds Basics
Shares of stock represent ownership (equity) in a company. Nearly all shares are either common or preferred stock. Stockholders assume most of the financial risk of investing in a corporation. If the company does well, the value of its shares will grow, but if the company fails, they are the last on the repayment list after creditors and bondholders.
Bonds, on the other hand, are “debt securities” issued by corporations to borrow money. Governments also issue fixed-income securities like bonds for the same reason.
How Bonds Work
Usually, the lower the credit rating of the bond issuer or borrower, the more high-yield their bond is likely to be. On the other hand, investment-grade bonds tend to have higher credit ratings and lower default risks. However, they also offer a lower rate of return.
Bonds usually pay fixed interest rates (called a coupon rate) and are redeemed for their par (face) value on the maturity date, which can be anywhere from a few weeks to 30 years or more.
However, zero-c0upon bonds don’t have interest rates associated with them during the bond’s lifetime, explains Investor.gov. Instead of interest payments, you get to buy them at a value that is less than their face value. You will then receive the latter value after the bond matures.
In addition, you could opt for convertible bonds. As a debt security, they offer specified interest rates and issue regular coupon payments. However, you can convert them into a specified number of common stocks. Alternatively, you can select agency bonds that are issued by a federal government-sponsored institution other than the U.S. Treasury.
Also, you can also opt for bond funds that invest in a variety of government and corporate bonds for enhanced bond diversification.
Relevant Stock Definitions
Below are some relevant stock and bond definitions you should know.
Common stock gives the owner voting rights at stockholder meetings and may pay dividends. A common stock that does not pay dividends may still be a good investment if the company is putting the money into expansion for the future.
The common stock of major corporations is traded on stock markets like the New York Stock Exchange and NASDAQ. Smaller firms’ stocks may be held privately or traded through brokers in the “over-the-counter” (OTC) securities markets.
Preferred stocks are a hybrid of common stocks and bonds. They are ownership shares but normally don’t have voting rights.
Preferred stocks and their dividends must be paid off before any funds go to holders of common stock. Most preferred stocks have substantial guaranteed dividends and are popular with investors seeking income, rather than equity growth.
Buying and Selling Corporate Bonds
Companies may choose to raise capital for expansion or to meet expenses when they issue bonds to borrow money instead of selling equity shares. The income investors get from bonds is fixed, and when you buy or sell bonds on the OTC market or on bond market exchanges, their price varies depending on prevailing interest rates, market conditions and the credit risk investors think the company represents.
Corporate long-term bonds may have maturities of up to 30 years. They are usually issued with face values of $1,000 or $5,000, which is the amount the company must pay at maturity to redeem the bond.
Trading Government Bonds
Like corporations, federal, state and local governments issue different types of bonds to pay for projects or cover expenses.
According to Investor.gov, U.S. Savings bonds are considered the safest bonds and are exempt from state and local income taxes. That’s because the U.S. government is the borrower. However, they are unavailable on the secondary market unlike other U.S. treasury bonds, such as Treasury bills and Treasury inflation-protected securities, or TIPS. The latter reduces your inflation risk.
State and local bonds (collectively called municipal bonds or “munis”), which are issued by municipalities, are similar, except the income from most is exempt from federal income taxes. Government bonds have bond prices whose par values range from $1,000 to as much as $10,000.
Money Market Basics
Both corporations and governments issue short-term securities with maturities of under one year and usually less than six months. These debt instruments are structured like other bonds, but trade on what is called the “money market.”
They are large-denomination securities and are not generally sold and traded by individuals but by large institutional investors. Corporate “commercial paper,” as these investments are often called, Treasury bills or “T-Bills” and short-term municipal bonds are the securities bought and sold by money market funds.
Investors with money market investments receive the interest, minus the fund’s fees, along with the tax breaks if the securities are government-issued. Although these investments pay fixed rates, they are so short-term that the makeup of a money market fund portfolio is always changing, so money market rates are variable.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.