SHARES VS BONDS - WHAT'S THE DIFFERENCE?
Roy Davidson, 24 October 2018
Shares and bonds are both important parts of any investment portfolio. Here, we explain the key differences between the two and when it might make sense to own more shares than bonds, or vice versa.
What are the key differences between shares and bonds?
Shares are an ownership stake in a company. When buying shares you’re entitled to your share of the company’s profits which you will receive through dividends, or through capital gains on your investment. With shares, you are participating to a larger extent in the success, or otherwise, of the company in question. Shares therefore offer the most upside, but also carry a greater degree of risk.
With bonds (also known as fixed income), on the other hand, you are essentially lending your money to a company (or government). In exchange for this you will receive regular interest payments at a fixed rate for a set period of time. You do not participate in the company’s success in the same way as if you owned shares, but bonds carry a lower amount of risk and provide much more income certainty.
To illustrate the differences, let’s look at an example.
Auckland Airport is listed on the NZX which means investors are easily able to purchase shares in the company. Auckland Airport also regularly issues bonds in the local debt market.
Let's assume, based on our forecasts, shares in Auckland Airport provide a gross dividend yield of 4.4%. On top of this, an investor would also benefit from any future positive performance. For example, if passenger growth picks up then shares would likely rise in value and dividends in future years would increase. Auckland Airport’s share price has risen by 12.9% per annum over the past five years while the dividend has increased from 12 cents per share in 2013 to 22 cents per share in 2018.
However, should performance deteriorate - maybe passenger growth stalls or there is an adverse regulatory ruling - shares could fall in value and an investor makes a negative return.
Another option is to purchase bonds issued by Auckland Airport. The company’s most recently issued bond currently provides investors with an interest rate of 3.45% until its maturity in six years’ time. These interest payments are highly predictable and provide investors with a steady source of income. But they offer no upside if Auckland Airport performs well.
Should you own shares or bonds?
An investor’s allocation between shares and bonds (along with other asset classes like property and cash) depends on a number of factors including time horizon, income requirements, and risk tolerance.
For example, a higher weighting to shares may be warranted if you have a longer-term investment horizon. This is because, while the return from shares is more volatile, they provide the greatest returns over the long-run.
However, if you expect to need to call on your investments in the next few years – perhaps a house deposit is on the cards – or reliant on the income from your investments for day to day expenses in retirement, then a higher weighting to bonds would be make sense.