The complementary relationship of stocks and bonds
When it comes to investing, opposites really do attract. Stocks and bonds are a great example of how two very different investments can come together to make a powerful combination. Like any power couple, stocks and bonds have a complementary relationship -- when one is weak, the other tends to be strong. Yup, that’s right. Stocks and bonds watch each other’s backs, and it’s smart to invest in both, so your investment portfolio has that same balance.
What are stocks and bonds, what are the benefits of owning each, and how do they complement each other? Let’s take a more in-depth look.
Stocks are shares of ownership in a company
In general, owning stock issued by a company allows you to benefit in two different ways if that company is successful: (1) dividend payments, which are distributions of corporate profits, and (2) increases in the stock price, which would also increase the value of your shares in the company. By owning stocks in a wide array of companies, via exchange-traded funds (ETFs) and mutual funds, you can potentially benefit from the long-term rise of the stock market and growth of the economy.
Bonds are debt issued by a company
Bonds, on the other hand, represent debt (or a loan) issued by a company. By issuing bonds, companies usually pay interest over time to bondholders and repay the full principal amount when the bond matures. By holding onto a bond until it expires, you can generate interest income (usually paid out annually or semiannually). Additionally, the price of the bond itself may fluctuate over time depending on many factors such as interest rates, corporate fundamentals, credit ratings, and more. If the bond price rises, this can be an additional source of return if a bondholder chooses to sell before the bond matures.
What makes stocks and bonds so different?
In short, stocks and bonds give investors rights to different parts of a company’s “capital structure” – that is, the different types of ownership within the company, which dictate how a company finances its operations and growth over time. This can be through debt in the form of bonds or through equity in the form of stocks.
Bondholders are at the top of the capital structure, meaning that bonds are paid back first, and are usually backed by some form of collateral, be it physical equipment or other assets. That’s why if a company declares bankruptcy, bondholders will be paid back before stockholders. That doesn’t mean you’ll receive a jet if you invest in an airline that goes bankrupt. It means that the equipment or assets of the company will be liquidated (turned into cash), and you will generally have the first claim to that cash as a bondholder.
In contrast, stockholders don’t have this level of safety. In fact, stockholders are the last to be paid – after everyone else above them in the capital structure, including bondholders. Stockholders are limited to being paid back with anything that’s left. When times are bad, there may be little left over. When times are good, and profits are rising, what’s left can be substantial.
Over time and across economic cycles, stocks may generate portfolio appreciation, which is a rise in value. However, that isn’t always the case. Stock dividends may or may not be paid to common shareholders at the discretion of the company’s board of directors. Bonds, however, generate steady income because they have a fixed interest payment schedule, but offer no potential for capital appreciation if the company does well.
Why is the negative correlation between stocks and bonds a good thing?
Because stocks and bonds typically behave quite differently, they help balance your investment portfolio. It’s very often the case that when stocks go up, bonds go down, and vice versa. In other words, when there’s a market downturn (e.g., during a bear market or recession), investors often turn to the safety and predictability provided by the steady income of bonds. Owning bonds can help cushion the blow and protect investors against stock market volatility. Investment professionals call this fact about the behavior of stocks and bonds a “negative correlation.”
Stock and bond market correlations across time Source: Clearnomics, Thomson Reuters
The chart above shows that stocks and bonds usually have a “negative correlation,” which simply means that when stock prices fall, bond prices tend to rise, and vice versa. Thus, the two asset classes can counter-balance one another, resulting in a more balanced, diversified portfolio.
Together, stocks and bonds may cushion losses
Together, stocks and bonds are good for your investment portfolio because when one decreases in value, the other tends to increase, helping potentially cushion your losses and smooth out volatility. Not only do stocks and bonds each serve essential roles on their own, together they’re a power couple that may be just what your portfolio needs.