November 29th, 2010
Peter from Plymouth, MA writes:
What is the difference between the stocks and bonds issued by the same company?
Friedenthal Financial:
Peter,
A corporation can raise money in a number of ways, including selling equity shares in the company (stock) and issuing debt securities (bonds). Investors can choose to buy a company’s stock or invest in their bonds, but there is a tradeoff between risk and return when making this decision.
Stock shares represent ownership in the company and often pay shareholders a dividend. These dividends can fluctuate over time, both higher OR lower. They are not guaranteed in any way. There is no expiry or termination date associated with shares of stock. Ownership remains until the shares are sold or the company dissolves.
Bonds are loans to a company and generally pay the bond holder (i.e. lender) an interest coupon. The bond has a specified maturity at which principal is to be repaid to the investor and generally has a constant interest rate. Some bonds are issued with a provision for the company to “call” their bonds, or repay them early under certain circumstances. All else equal, bonds that are “callable” pay a higher yield to compensate the investor for taking this added risk.
The other main differences between various stock and bond issues of a specific company pertain to the order of credit exposure in the event of bankruptcy and/or liquidation of the company. Bonds can be issued with a specified seniority with respect to credit exposure. The “senior” bonds are the first to get repaid in bankruptcy. Subordinate (junior) bonds would be repaid next. Stock holders are the last to get paid, if funds remain after selling assets and paying off liabilities (including all bonds). Some companies have more than one class of stock shares as well. If this is the case, “preferred” shares get paid after the subordinate bonds, but BEFORE the common stock shareholders.
The two primary risks of owning a corporate bond are the reinvestment risk (how long the investor has to wait to receive cash-flows to reinvest at current market rates) which make it sensitive to changes in interest rates and the credit risk (risk of not receiving cash-flows due to default). The maturity of the bond is generally the main driver of sensitivity of interest rate risk, while credit quality of the issuer (usually measured by credit rating….although this has been heavily scrutinized in the past few years) is the main driver of perceived credit risk. If the market perceives a greater risk of default, the bond price decreases.
Bonds issued by highly rated corporations tend to be more correlated with treasuries (although they still require higher interest rates than treasuries) since their risk of default is considered relatively low. Lower rated corporate bonds often fluctuate with the stock market, since risk of default correlates with depressed equity prices.
Below you will find statistical charts of High Yield Corporates (Ticker: HYG), Investment Grade Corporates (Ticker: LQD), 7-10 year US Treasuries (Ticker: IEF), and the S&P 500 (Ticker: SPY). As mentioned above, the low grade corporate bonds have material correlation to stocks {HYG vs. SPY – chart 1} and have no correlation to US Treasuries {HYG vs. IEF – chart 3}. The High Grade Corporates exhibit some correlation to Treasuries {LQD vs. IEF – chart 4} but no correlation to stocks {LQD vs. SPY – chart 2}. If we examined only the highest grade corporates (only AAA/AA) we would find even higher correlation to treasuries.
Chart 1 – High Yield Corps vs Stocks (Look at the R^2 to compare charts)
Source: Bloomberg
Chart 2 – Investment Grade Corps vs Stocks
Source: Bloomberg
Chart 3 – High Yield Corps vs Treasuries
Source: Bloomberg
Chart 4 – Investment Grade Corps vs Treasuries
Source: Bloomberg
We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!
The Friedenthal Financial Team
856-210-6494 (Office)
856-210-1565 (Facsimile)
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