Investing Basics Explained: The Difference Between Stocks and Bonds
Do you want to start investing, but you're confused about the different terms and concepts?
Here are the main ways to invest in companies, and the differences between the different ways: Investors can buy a company's stock or its bonds.
Either way, the investor is exposed to the risk and potential return the company can provide investors that hold its assets.
Bonds Bond holders get paid first out of all asset holders of the company.
Holding a company's bond means the investor owns claims on the company's debt, or the interest it pays to lenders.
The investor get fixed payments, which are a percent interest on the money paid to own the bond.
The debt is paid after operating expenses, but before taxes, so well before stockholders get paid.
This means the investor is taking minimal risk of losing principal, or the amount spent to buy the asset.
Bonds are usually less risky than stocks are, but they also usually don't return as much.
Stocks A stock represents ownership of the residual value, or equity, of the company, so claims on the company's assets after all obligations are paid.
This is after taxes and well after debt payments.
If a company has 100 shares outstanding, and an investors owns 1, he or she owns 1% of the equity (chances are, if an investor owns 1% of a company with billions of shares, that investor is a big wealthy investment fund).
Mature and stable companies pay dividends, but it's future profits that count.
When the market expects future profits to rise considerably, the value of the shares can shoot up.
Of course, that value can shoot way down for the opposite expectation.
Companies can either see huge declines in profits or huge increases, makings both more risky, but also potentially more profitable than bonds.
Preferred stock holders are the first of stockholders to get paid, and then common stockholders.
Preferred stockholders get their dividends first, and sometimes they get a bigger dividend.
Preferred stockholders don't have voting rights for big company decisions, while common stockholders do.
The difference between preferred and common has a lot to with bankruptcy.
In the case of bankruptcy, a company liquidates all assets, turning them into cash (selling assets and collecting receivables).
First, all parties owed money by the company are paid.
Then, bond holders are paid.
Company's have three parts to their debt structures: senior debt, mezzanine debt and junior debt.
Senior debt holders are paid first, then mezzanine holders and then junior debt holders.
Usually, junior debt has a higher interest rate, as the bondholder is being compensated for taking the risk of being the last bondholders paid.
Then, preferred stockholders are paid their cash.
Then, common stockholders are paid.
For more investing education, check out TheStreet courses where Jim Cramer breaks down the Fundamentals of Investing.