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Stocks give you partial ownership in a corporation, while bonds are a loan from you to a company or government. The biggest difference between them is how they generate profit: stocks must appreciate in value and be sold later on the stock market, while most bonds pay fixed interest over time.
Here's a deeper look at how these investments work:. Stocks represent partial ownership, or equity, in a company. Now imagine, over several years, the company consistently performs well. Of course, the opposite is also true. If that company performs poorly, the value of your shares could fall below what you bought them for.
Stocks are also known as corporate stock, common stock, corporate shares, equity shares and equity securities. Companies may issue shares to the public for several reasons, but the most common is to raise cash that can be used to fuel future growth. Bonds are a loan from you to a company or government.
Put simply, a company or government is in debt to you when you buy a bond, and it will pay you interest on the loan for a set period, after which it will pay back the full amount you bought the bond for. The durations of bonds depend on the type you buy, but commonly range from a few days to 30 years. Likewise, the interest rate — known as yield — will vary depending on the type and duration of the bond.
Learn how to buy stocks and how to invest in bonds. While both instruments seek to grow your money, the way they do it and the returns they offer are very different. See how stocks and bonds might fit into your asset allocation. To calculate the return on this average capital, the analyst divides the after-tax net profit by average shareholders' equity and multiplies the result by This number is also referred to as return on average shareholders' equity and represents the rate at which money invested in a business is growing.
Bondholders lend money to the corporation. Therefore, like all lenders, they are owed a specific sum regardless of the company's profits.
Failure to pay bondholders will have serious legal consequences, including seizure of assets or even bankruptcy. Issuing bonds to finance a project will increase ROI if the increase in profit resulting from the new investment exceeds interest paid to bondholders. Selling stock doesn't create a payment obligation.
If the board of directors deems it more prudent not to pay shareholders, they have no recourse and must wait. However, when money is distributed to shareholders, it must be paid equally to new and longtime owners. Bonds release firms from the restrictions that are often attached to bank loans.
For example, banks often make companies agree not to issue more debt or make corporate acquisitions until their loans are repaid in full. Issuing bonds enables companies to raise money with no such strings attached. Issuing shares of stock grants proportional ownership in the firm to investors in exchange for money.
That is another popular way for corporations to raise money. From a corporate perspective, perhaps the most attractive feature of stock issuance is that the money does not need to be repaid. There are, however, downsides to issuing new shares that may make bonds the more attractive proposition.
Companies that need to raise money can continue to issue new bonds as long as they can find willing investors. The issuance of new bonds does not affect ownership of the company or how the company operates. Stock issuance, on the other hand, puts additional stock shares in circulation. That means future earnings must be shared among a larger pool of investors.
More shares can cause a decrease in earnings per share EPS , putting less money in owners' pockets. A declining EPS number is generally viewed as an unfavorable development. Issuing more shares also means that ownership is now spread across a larger number of investors.
That often reduces the value of each owner's shares. Since investors buy stocks to make money, diluting the value of their investments is highly undesirable. By issuing bonds, companies can avoid this outcome. Bond issuance enables corporations to attract a large number of lenders in an efficient manner.
Record keeping is simple because all bondholders get the same deal. For any given bond, they all have the same interest rate and maturity date. Companies also benefit from flexibility in the significant variety of bonds that they can offer. A quick look at some of the variations highlights this flexibility. The basic features of a bond— credit quality and duration—are the principal determinants of a bond's interest rate.
In the bond duration department, companies that need short-term funding can issue bonds that mature in a short time period. Companies with sufficient credit quality that need long-term funding can stretch their loans to 30 years or even longer. Perpetual bonds have no maturity date and pay interest forever. Better health and shorter duration generally enable companies to pay less in interest. The reverse is also true.
Less fiscally healthy companies and those issuing long-term debt are generally forced to pay higher interest rates to entice investors. One of the more interesting options companies have is whether to offer bonds backed by assets.
Such bonds are known as collateralized debt obligations CDOs. In consumer finance, car loans and home mortgages are examples of collateralized debt. Companies may also issue debt that is not backed by underlying assets. In consumer finance, credit card debt and utility bills are examples of loans that are not collateralized. Loans of this type are called unsecured debt.
A small startup, particularly a partnership or sole proprietorship, may have to rely on loans. Business News Daily advises that raising money through debt has advantages. If you sell an ownership share in your company, you dilute your control; that doesn't happen if you take out a loan. You know exactly how much you have to repay, when the payments are due, and what the interest is.
At tax time, you can write off the interest on the loan. The bad news? Paying back the money can take a bite out of your income, particularly if the interest rate is steep. For example, if you take out a loan to expand, you may have to start paying back the money before the expansion generates more income.
The payments aren't an expense you can economize on or skip. If you hit a rough patch and can't make the payments, you might end up in bankruptcy court.
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