If you have studied finance, or even if you’ve just read about finance casually online, you probably know that stocks and bonds are very different things. Bonds are more like debt, where you lend money to an institution and they pay you interest until they pay the principal; stocks, however, operate like ownership, providing you with an equity stake in a company–but that company does not have an obligation to pay you interest on that stock.
That is the first point of consideration when we think about how these are fundamentally different things. Bonds are bought for the cash flow; the upside from getting a profit on your purchase is (usually) nonexistent. Stocks are the exact opposite: when they do provide cash flow, like dividend-growth stocks, their yield is usually very low, but they can also provide tremendous capital gains profits if the company grows and there’s greater demand for stocks.
That’s the first way that bonds and stocks are treated differently: the first is for cash flow, the second for capital gains.
But there’s much more to it. Many bonds, especially over the last decade, have provided very little income. 10-year Treasuries pay nearly 3% these days, and that’s shockingly low compared to the 5%+ that they have paid at many points throughout history. It’s also not much more than many dividend-growth stocks, where there is capital gains upside and relatively little risk of price declines in the long term.
So why buy Treasuries?
To answer this question, let’s think of a more absurd example: corporate bonds for dividend-yielding stocks. For many dividend growth blue-chip stocks, the yields on their bonds is less than the yield on their stocks–yet the stocks provide additional upside potential. This juxtaposition looks particularly ridiculous, yet the reason that yield on bonds is so low is because demand for them is so high, despite their lower potential.
Again, so why buy bonds?
The first answer relates to institutional demands, which exceed pure returns. For instance, a hedge fund or a pension fund might have a mandate that requires a particular portion of the fund is liquid–or maybe the fund manager wants a certain portion of the fund to remain liquid as part of its investment strategy. Bonds are less volatile, thus more liquid, so they’re a better choice than stocks in that case.
There is also the potential of the secondary bond market. While capital gains on bonds are very rare if bought when first issued, they can be found on the secondary market. If someone buys a bond at issuance, they will pay full price (“par value”) of the bond. However, the market price of that bond may go down in the secondary market for a variety of reasons. If the company’s financials suffer, or its credit gets downgraded, or there simply aren’t enough buyers in the market, suddenly a bond can sell at a discount, or below par. Institutional investors can swoop in, buy, and then resell at a profit.
A third way to profit from bonds is the macroeconomic bet. Bond values vary according to interest rates, inflation, and other big picture issues. An institutional investor may want to buy some bonds as a bet on a particular macroeconomic trend–better-than-expected economic growth in a country, or big fluctuations in a currency. Bonds serve this end as well.
Bond investing is similar but importantly different from stock investing, and in many ways it can be more exciting. Plus, bond markets are substantially less efficient than stock markets, because they are less liquid and there are less market participants. A budding financier could do worse than to plan for a job analyzing and trading bonds.