Key takeaways
- A stock is a share of ownership in a company; a bond is a loan to a government, municipality or corporation.
- Bonds promise interest and the return of principal at maturity; stocks offer no promise, but the greatest long-term growth potential.
- In a liquidation, bondholders are paid before preferred and then common stockholders, who may receive nothing.
- Bonds still carry risk: credit, interest rate, inflation, liquidity and call risk. Prices of existing bonds fall when rates rise.
- Investor.gov ties the mix of the two to time horizon and risk tolerance, and rebalancing restores the mix as markets move.
Stocks and bonds are two basic building blocks of a portfolio, and they work in opposite ways. Investor.gov's summary is a good place to start: with a stock, you are purchasing a piece of ownership in a company; with a bond, you are lending money to it, or to a government. Almost every difference between them follows from that.
The core difference
| Stock | Bond | |
|---|---|---|
| What you hold | A share of ownership | A loan to the issuer |
| Who issues it | Companies | Companies, the U.S. Treasury, states, cities and other government entities |
| How it pays you | Possible dividends, and any rise in the share price | Interest at a specified rate, usually on a set schedule such as every six months |
| Principal | No promise; the price can fall to zero | Promised back at maturity, if the issuer does not default |
| Growth potential | Investor.gov calls stocks the greatest potential for growth over the long haul | Mainly the interest; prices before maturity move with rates |
| In a bankruptcy | Common stockholders are last in line | Bondholders are paid first |
What a stock is covers shares in more detail, and how dividends work explains the payments.
Who gets paid first
Investor.gov sets out the order when a company goes bankrupt and its assets are liquidated: bondholders are paid first, then holders of preferred stock, and common stockholders get whatever is left, which may be nothing. That ordering gives bondholders a prior claim on whatever is left, which is why a company's bonds can be worth something even when its stock is worthless.
Kinds of bonds
Investor.gov groups bonds into three main families:
- U.S. Treasuries, which carry the full faith and credit of the U.S. government. They range from Treasury bills maturing in a few days to 52 weeks, to bonds that typically mature in 30 years. TIPS adjust their principal for changes in the Consumer Price Index.
- Municipal bonds, issued by states, cities, counties and other government entities. Their interest is generally exempt from federal income tax.
- Corporate bonds, split into investment-grade, with higher credit ratings, and high-yield bonds, which pay higher interest because of their higher credit risk.
Bonds have risks too
"Safer" does not mean safe. Investor.gov lists five risks:
- Credit risk: the issuer may fail to pay interest or principal on time and default.
- Interest rate risk: changes in rates affect a bond's market value.
- Inflation risk: inflation erodes the purchasing power of fixed interest payments.
- Liquidity risk: you may not find a buyer when you want to sell.
- Call risk: the issuer may repay the bond early, typically when rates have fallen.
Why rising rates push bond prices down
Investor.gov explains interest rate risk this way: when rates rise, newly issued bonds pay more, so to sell an older, lower-rate bond before maturity you may have to accept a discount. Held to maturity, you still receive the face value plus interest.
A simplified illustration, using a $1,000 bond paying 3% ($30) a year, if new bonds of the same quality now pay 5%:
| Years left to maturity | Approximate price a buyer would pay |
|---|---|
| 2 | about $963 |
| 10 | about $846 |
The longer the bond has to run, the more years of below-market interest the buyer is accepting, so the bigger the discount. If rates instead fell to 2%, the same 10-year bond would be worth about $1,090. These figures assume annual payments and identical credit quality; real bond pricing has more detail.
Stocks swing more
Investor.gov notes that investors who held stocks for long periods, say 15 years, have generally been rewarded with strong positive returns, but that there is no guarantee and you can lose money. Large-company stocks as a group have lost money on average about one out of every three years. If you have to sell during one of those years, the loss is real.
Holding both
Investor.gov's guidance on asset allocation explains why investors may combine the two. Market conditions that make one asset class perform poorly may improve returns for another. Investors with longer time horizons may be more comfortable with riskier, more volatile investments; those nearer their goal may prefer less volatility.
Mixes drift as markets move. Investor.gov's example: a portfolio started at 60% stocks can rise to 80% after market gains, and rebalancing, selling some stocks or adding to other assets, restores the original mix. Diversification and risk tolerance explain how to think about the right proportions, and compound interest shows how either kind of return builds over time.
Learn to Trade Stocks Beginner, one of our education apps, focuses on stocks and uses virtual money only. The investing basics hub lists the related guides.
Good to know
Frequently asked questions
What is the main difference between stocks and bonds?
Are bonds safer than stocks?
Why do bond prices fall when interest rates rise?
Who gets paid first if a company goes bankrupt?
Sources
- Bonds – FAQs (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Stocks – FAQs (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Asset Allocation and Diversification (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
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