#508 - How Does A Bond Differ From A Stock?

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Feb 12, 20195m
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#508 - How Does A Bond Differ From A Stock?
Feb 12 '195m
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Hey everyone. This is Kirk here again at Option Alpha and welcome back to the daily call. Today, we’re going to answer the question – “How does a bond differ from a stock?” If you’ve just started investing or even if you've been investing for a little while now, you might hear these terms and think that they're interchangeable, bonds and stocks, stocks and bonds, but the reality is that they are quite different from one another. The only similarity that they actually share is that in many cases, they are structured investments and you can just as easily buy a bond as you can buy a share of stock. But at that point, they start to diverge just a little bit in some of their qualities and I wanted to go through that quickly here on today's podcast.

One of the major differences between stocks and bonds is that stock ownership is a second or third level ownership in a company compared to bondholders. What we typically refer to as bondholders is having kind of seniority bond-holding position or a seniority position in a company, so whereby, if a company was to go bankrupt or go into liquidation mode, the bondholders would get paid first and then stockholders get paid after that. Depending on the corporate structure and if a company actually has debt that’s been issued through bonds or they just have equity through stock, then that structure might be a little bit different, but in many cases, bondholders serve a more seniority role or position when a company goes through liquidation. In that case, it carries a little bit less risk. If a company is going to be liquidated, the bondholders get paid first and whatever's left is divided up among the stockholders.

Bonds are also structured products. When you typically hear about a bond, it has a defined face value, sometimes $1,000 in face value to purchase the bond and a defined structure of payments, so a coupon or interest rate of say 5% per year for the next five years or the next 10 years, 5% per year, so a very structured and logical process by which the bonds are issued. Stock on the other hand, does not have that. Stock is ownership in the underlying company and in many cases, that ownership is being traded at a much faster pace and the fluctuations in value happen at a much greater magnitude as the company starts to generate money and starts to work its business model. Stocks can be paid dividends, but those dividends are never assured and sometimes those dividends can rise, sometimes they can go away, so stock ownership is generally considered to be a little bit more risky.

Now, this doesn't mean that bonds don't trade and don't increase or decrease in value. Sometimes what we see happening is that bonds will start trading at a discount to their face value if we start to see that other investments that are of the same risk caliber as the particular bond that you’re trading right now have a better or higher payout. Let's say you bought a bond originally at a 5% coupon or interest rate and now, the company offers the same potential bond for now a 6% interest or coupon. Well, your old bond that you had previously purchased is now potentially worth a little bit less money. It’s going to trade at a discount because an investor coming in could buy the new face value bond of $1,000 for 6%. Why would they ever buy your face value of $1,000 for a 5% coupon? That bond that you had originally bought first is now going to trade in at a little bit of a discount.

That’s how they kind of move and shake and ebb and flow in the market, but again, there's a lot of little nuances and differences in bonds. Hopefully I just covered some of the broad strokes and highlights of these two different classes of investing. I think when you think about building out portfolios, whether you’re trading options or whether you’re trading actual stocks and bonds, having exposure to both of these classes is really, really critical. What we do here at Option Alpha is we typically have a bond type position on at all times where we’re trading options around bond prices and we like to have that type of exposure in our portfolio because it helps diversify the rest of our positions and reduce volatility overall. As always, if you have any questions, let me know and until next time, happy trading.

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