Corporate High-Yield Bonds Vs. Equities

There are a variety of options available to investors looking for a strong return. Two of the most popular investment options are equities and higher-yielding corporate bonds. While well-chosen equity investments always outperform corporate bonds in the long haul, from a portfolio perspective, almost all finance and investment advisors agree on the benefits of diversifying your investments by choosing to invest in corporate bonds as well as equities. In the following paragraphs, we conduct a comparison of these asset classes.

On the surface, there’s quite a bit of similarity between equities and corporate bonds: Both allow businesses to secure funding for their operations, and both offer investors a way to invest into a business to achieve a return on their investment. So the big difference between the two is the agreement that’s established between the bondholder and bond issuer vs. the agreement established between a stockholder and a stock issuer as well as the amounts the stock or bond will pay out.

Investing in stock makes an investor a part owner of a company. When you become a stock owner, you have nothing guaranteed. The expectation is that the stock you purchased will appreciate in value and, in some cases, pay dividends. However, as anyone familiar with the struggles of the stock market knows, nothing in the stock market is guaranteed. The price of stocks, or shares, can fluctuate rapidly—going up or down regardless of how the company itself is performing. In exchange for the added risk and volatility of stock ownership over bond ownership equities typically have a much higher ROI potential than even higher-yielding corporate bonds.

Investing in corporate bonds makes the investor a creditor of the company. While a stockholder is guaranteed nothing, owning a bond entitles the investor to interest payments (zero-coupon bonds excluded) as a creditor on their bond purchase as well as the promise that the bond will eventually be repaid at 100% (given that the corporation doesn’t go bankrupt). Investments in high-yield corporate bonds are considered less risky due to less volatility compared to equity investments. So yes, stocks can provide more ROI in the long run, but they are not as stable and do not guarantee a fixed interest payment as dependable income. However, the important keyword in the last sentence is “in the long run”: by investing in stocks, any investor should be prepared to provide a medium- to long-term investment horizon and avoid investing funds that may be needed in the short term. For these reasons, corporate bonds will continue to remain less lucrative when all goes right with stocks. Your returns are capped in a way an investment in stocks never is.

There are a few additional key points investors should keep in mind concerning any investments in higher-yielding corporate bonds:

No corporate bond is fail-safe. Yes, they are less risky than a stock, but just like stocks, there truly is no guarantee that you will get your money back and, yes, you can lose all of your principal. Investors must perform their due diligence to evaluate corporate bonds just as they would stocks to protect themselves from the chance of default.

A bond is never going to “do an Apple” and grow to 100 times its original amount. The primary reason investors choose stocks is the vast top-end potential for ROI. A corporate bond has a capped amount of returns, so even if you are a bondholder for a small company that hits it big, your ROI will not go up accordingly. Additionally, this severely limits the scope of a bond’s ability as an asset class to make up for individual losses by outweighing them with larger gains elsewhere the way stocks can.

Companies reinvest bonds’ credit to earn a profit, meaning shareholders have their income generated by bondholder investments. When an investor buys a corporate bond that pays interest, the company issuing that bond is using the investor’s funds to reinvest in itself as a business.

Corporate bonds simply are not as easy to appraise as stocks are. Investing in a corporate bond only makes sense when you can know how likely it is that the company issuing it will truly make the interest payments without going bankrupt—this clearly requires an in-depth stream of financial information. It also requires knowing what you are likely to get back if the company does go bankrupt. There is no real way to evaluate this without knowing more about the company itself and how it conducts its business. This means prudently evaluating a corporate bond is often more time consuming and costly than investors realize.

There are specific types of corporate bonds that are “callable” by the issuer and that can limit their overall return potential. This is typically done by a bond issuer to allow them the options of refinancing to less expensive debt in the event of a drop in interest rates. The flip side of this is that a corporate bondholder has no recourse to perform the same action in the event the interest-rate rises. So this makes bonds less attractive if their rate rises. In general, any potential investor should be aware that there are various types of corporate bonds in the market: These encompass, among others, split-coupon issues, pay-in-kind bonds, zero-coupon bonds, floating-rate bonds, deferred-interest bonds and convertible bonds and so on. (See also: High Yield Corporate Bonds: Different Structures and Types).  

When push comes to shove, companies  have their interests more closely aligned with shareholders, not bondholders. This is because a bondholder is a creditor and not a part owner of the company. This means that bondholders negatively affect the company’s books while stockholders positively affect their balance. Additionally, the director of most large companies typically has a large part of their personal wealth tied up in stocks, which means they personally, by definition, have the stockholder interests more closely at heart than that of bondholders. This means that any opportunity that a director or company management has to positively impact stockholder returns at the cost of bondholder returns is typically one that makes good business sense. A strong example of this playing out in the real world is a leveraged buyout, where the company’s credit rating is downgraded, reducing the payout to bondholders while at the same time creating a bidding war from those attempting to buying it out.

Despite the significant differences between stocks and corporate bonds, we recognize that both asset classes have important features as well as benefits. Any investor considering adding corporate bonds to their portfolio should clearly define his or her risk/return profile. It is valuable to consider diversifying across both asset classes.