We’ve all grown up on proverbs. We like them because they explain life’s truths in a pithy way. For example, “Rome wasn’t built in a day” reminds us that creating good things takes time. Another, “There is no rule without an exception,” reminds us that no rules, even when stated as proverbs, are a hundred percent true in every instance. Investors also have a proverb that says, “bonds are safer than stocks.” That might be true as a general rule. But as with every rule, there are exceptions—enough so that investors who don’t understand them could take on more risk than they realize.
Understanding the Key Difference Between Stocks and Bonds
Understanding how bonds may not be safer than stocks begins with some insight into how companies utilize bonds and stocks to raise capital. The first way companies raise capital is by selling equity to the public, who then owns a portion of the company as shareholders. The second way is to borrow money from the public, who then become creditors to the company as bondholders. Many companies utilize both methods, which are combined to create their total capitalization.
One of the reasons bonds are considered safer than stocks is that bondholders hold a senior position to stockholders—meaning that, if the company goes under, bondholders get paid first. In some situations, stockholders may walk away with nothing.
Another way to look at it is that issuing stock is low risk for the company, but it is high risk for investors while issuing bonds is high-risk for the company but low risk for investors. But consider this: Companies that fund their entire operations through shareholder’s capital are generally in good financial health. They’re able to fund operations and grow the company strictly through its earnings. The likelihood of shareholders walking away with nothing is slim at best.
The Inherent Risks of Highly Leveraged Companies
Companies that need to borrow to raise capital take on debt which can be a drag on earnings. With companies that are highly leveraged, with more than 70% of their capital coming from debt, bondholders are, in essence, on the hook for most of the company. If the company goes bankrupt, bondholders will get paid before stockholders, but they still might not get paid.
Of course, stockholders may not get anything back, but then they understand the risks of investing in stocks and may not be reliant upon their investment for income. Plus, stock investors tend to take a longer-term view of their investments, enabling them to weather short-term storms. Conversely, bondholders have a more short-term mentality because they rely on bond interest for income. Some may have bonds maturing in a few years and expect their principal to be repaid to them. Their interest is not so much in the business as it is getting their interest and principal.
You Get What You Pay For
Then there is the notion of value or getting what you pay for. Consider two investment alternatives. You could invest in a company that has been paying a 4% dividend for the last ten years, increasing it each of those years. The company has little or no debt and has been compounding its growth for several decades. You have a ten-year time horizon.
Or you could take the “safer” route and invest in a ten-year Treasury bond paying one and a half percent interest. Of course, there could be no expectation of an increase in principal value, and the interest payment is fixed.
Which alternative would you consider to be riskier?
With the Treasury bond, you are virtually guaranteed to underperform inflation. Yes, your interest payments and principal are guaranteed. But considering you would be losing your purchasing power each year you hold the bond, it is only an illusion of safety.
There is no illusion with the stock investment. The reality is you own a piece of a dividend-paying company that has been growing for 30 years, with prospects for more growth. While dividend payments are not guaranteed, companies will go to great lengths to continue them as a way to reward shareholders.
While there is always risk in owning stocks, it’s mitigated in this case with the 4% dividend payment. The risk of losing purchasing power with a bond paying 1.5% is not mitigated—it is certain to happen. So, which is less risky?
Bonds are Expensive
Finally, it’s essential to consider the price you’re paying for an investment. You certainly don’t want to purchase a stock that is overvalued because it limits your upside while leaving more room to fall on the downside. The same applies to bonds purchased in the secondary market. Bonds today are overpriced—meaning their current prices exceed their face value.
If you purchase a bond with a face value of $100 and its current price is $105, you are guaranteed a loss if you hold it to maturity. And, in this interest rate environment in which the only direction rates can go is up, you are not likely to be able to sell it at a higher price because, when rates increase, bond prices decrease.
Final Thoughts
One reason investors tend to believe bonds are safer than stocks is that they are almost always advised to add them to their portfolio for diversification. Bonds and stocks tend to be uncorrelated so, when stock prices increase, bond prices decrease and vice versa. But even that rule has exceptions. Regardless, that doesn’t mean bonds are safer than stocks. It means that the strategy of diversification can make your portfolio safer.
Presently, we underweight bonds in our portfolio, having sold down our positions over the last couple of years for many of the reasons discussed here. That may change when interest rates rise again. Still, right now, owning high-quality, debt-free companies, especially when purchased at a discount to their intrinsic, or “par value,” appears safer than bonds at this time.
