Stocks and bonds are two of the most common investment vehicles. Both can be beneficial to your organization’s investment portfolio. How much you invest and where depends on your risk tolerance, timeline and investment goals.

By understanding what bonds and stocks are, how they work and the benefits of each, you will be able to make sound and strategic investment decisions that meet your company’s needs.

What are bonds?

Bonds are fixed-income securities that allow investors to act similarly to lenders. Unlike stocks, they offer no ownership rights but instead provide predetermined payments over a specific term, typically ranging from 10 to 30 years. As unsecured debt instruments, bonds are actively traded in secondary markets.

Bonds come with a variety of terms. Most require the issuer to make semiannual interest payments at a fixed coupon rate throughout the bond's life. Upon reaching maturity, the bond's full principal is then repaid to the holder.

The relationship between issuer and bondholder is governed by a bond indenture — a legally binding contract that can impose restrictions on the issuer's financial activities, including limitations on asset use, working capital management, dividend payments and additional debt acquisition. Any violation of these covenants can impact bond values.

Some indentures include call provisions, allowing issuers to repay bonds early, often to refinance at lower rates. Conversely, put provisions grant bondholders the option to sell bonds back to the issuer before maturity, typically at a discount.

The U.S. bond market stands as the world's largest. European companies are expanding their bond market utilization, and China, Japan and Australia maintain substantial debt security markets.

Types of bonds

There are nine main types of bonds:

1. Mortgage bonds are used to finance specific assets, including real estate and manufacturing equipment. In this case, the assets serve as security against the issue. This type of bond also typically includes substantial financial covenants or indenture agreements.
2. Debentures are unsecured bonds backed by an issuer’s general assets or cash flows and often offer higher interest rates than secured bonds. They can be issued by governments, corporations or municipalities. Financially strong organizations issue them based on their credit rating, while others use them when they lack easily securitized assets.
3. Convertible bonds are corporate debt securities that can be, as the name implies, converted by the holder (and sometimes the issuer) into shares of common or preferred stock at a fixed ratio of shares per bond. This type of bond provides the investor with the potential for capital growth. Because of this, investors may be willing to accept a lower interest rate on these bonds.
4. Sovereign bonds, or sovereign debt, are issued by national governments, typically in their own currency. They are subject to a higher level of political risk than other bonds, as governments could use debt repayment decisions for diplomatic leverage. Because these bonds are often issued in the originating country’s currency, risks such as foreign exchange fluctuations and higher default risk should be considered.
5. Sub-sovereign bonds are issued by states, provinces or municipalities. In the U.S., these are commonly known as municipal bonds or "munis." While most of these bonds are issued in the U.S., the global market is growing as local governments seek funding for public services and infrastructure projects. Sub-sovereign bonds can be either general obligation bonds, repaid through general tax revenue, or revenue bonds, which are paid back using income from specific projects like toll roads or public utilities. They’re subject to local regulations and tax rules, e.g., U.S. municipal bonds are exempt from federal income tax.
6. Eurobonds, also called an external bond, is an international bond issued in a currency different from the country where it’s sold. For example, a U.K. company could issue a Eurodollar bond (denominated in U.S. dollars) in India. Sold across multiple countries, Eurobonds offer issuers flexibility in choosing the currency and location, making them a useful tool for multinational organizations to manage foreign exchange risks.
7. Zero-coupon bonds don’t pay interest and are issued at a discount to their par value. Issuer benefits include no cash outflow until maturity and the receipt of annual tax deductions. These bonds can’t usually be called or refunded, and investors must pay taxes on imputed interest each year, even though no payment is received until the bond matures. This can create a negative cash flow due to taxes if the bond is not in a tax-exempt portfolio.
8. Floating-rate securities, or floaters, have interest payments that adjust periodically based on an index, such as SOFR or SONIA, with a rate typically set as a spread above the index (e.g., SOFR + 3%). The reset can occur at varying intervals, such as daily or monthly. These appeal to investors when interest rates are rising as they maintain market value, and a rate decline makes them more attractive to borrowers.
9. High-yield bonds, also referred to as junk bonds, are issued by less creditworthy entities and have ratings of BB+ or lower (S&P) or Ba1 or lower (Moody’s). These bonds offer higher returns to offset the increased risk of default. If an investment-grade bond is downgraded to junk status, its price may drop as many institutional investors are prohibited from holding such securities.

There are also many other types of bonds that are used for special purposes or are related to specific types of assets, such as economic development bonds, foreign bonds and ESG bonds.

Bond ratings

Bonds are assigned quality ratings based on the default probability of the issuer. One or more accredited agencies rate the issuer. While the rating service is paid for by the issuer, agencies have a strict divide in place between analysts (those who rate the issuers) and customer relations teams.

Corporate issuers should consider three key aspects of credit ratings:

1. Rating criteria: Each agency has its own criteria, and ratings are based on both qualitative and quantitative factors — such as market share, profitability and leverage — which vary by industry.
2. Importance of ratings: Many institutional investors can only buy investment-grade bonds, so ratings affect the firm's cost of capital and investor demand.
3. Changes in ratings: Agencies review ratings periodically, and downgrades can make it harder and more expensive for firms to raise capital.

What are stocks?

Stocks represent ownership shares in public corporations and are a fundamental component of the equity market. When an investor purchases a stock, they acquire a portion of ownership in the company, entitling them to a share of its assets and earnings — and allowing companies to raise capital for operations and expansion.

The stock market operates on two levels: the primary market, where new stock issues are sold, and the secondary market, where existing shares are traded. The advancement of technology has enhanced both the accessibility and efficiency of stock trading. Many stocks are now cross-listed on multiple exchanges worldwide, either directly or through depositary receipts, which benefits both investors seeking diverse portfolio options and corporations aiming to broaden their investor base.

Types of stocks

There are two types of stocks: common and preferred.

Common Stock

Common stocks represent ownership shares in a company. When investors purchase common stock, they become partial owners of the firm, participating in its financial success or failure, and representing a crucial source of capital for most publicly traded companies. Institutional investors hold the majority of common stock in the market.

Familiarity with some key accounting terms is required to understand how common stocks work.

• Par value, often set at $1 per share or even $0, is an arbitrary amount stated in the corporate charter.
• Additional Paid-in Capital (APIC) reflects the difference between the par value and the price at which new stock is issued.
• Retained earnings represent the accumulation of a company's profits over time, minus any dividends paid out to shareholders.

The stockholders' equity section of a balance sheet combines these three elements and provides a historical accounting of the company's equity. That said, the book value often differs considerably from the stock’s current market value — the price at which shares are actively traded.

Companies may choose to repurchase their own shares, creating what's known as treasury stock. These re-acquired shares don't receive dividends or carry voting rights, and they're considered issued but not outstanding. Treasury stock can be held indefinitely, used for employee compensation plans, reissued to the public or retired.

Most firms have a single class of common stock, but some issue multiple classes, which allows them to cater to different investor preferences. These classes, often labeled as A or B, may have varying voting rights, dividend policies or resale restrictions.

A more specialized form of common stock is tracking stock, which is tied to the performance of a specific business unit within the company. Investors can buy into a particular segment without investing in the entire firm; however, it doesn't accord ownership or voting rights in the parent company.

Preferred Stock

Preferred stock bridges the gap between common stock and debt. Unlike common stock, preferred stock typically doesn't grant voting rights, which allows companies to raise capital without diluting control. This characteristic makes it an attractive option for firms seeking to expand their financial resources while maintaining their existing governance structure.

One of the key features of preferred stock is its dividend structure. Preferred stockholders receive dividends at fixed rates, often for the life of the security or in perpetuity. This predictable income stream makes preferred stock behave more like debt in terms of cash flow. However, missing a preferred stock dividend doesn't put a company at risk of bankruptcy — unlike missing interest payments on debt. This provides companies with more financial flexibility, albeit at a higher cost since preferred dividends are not tax-deductible.

Preferred stockholders enjoy a priority claim on both earnings and assets, which means that in the event of liquidation or dividend distribution, they are paid before common stockholders. Most preferred stock issues also accumulate dividends in arrears; any missed dividends must be paid before common shareholders receive any dividends.

These stocks often come with additional provisions that may include voting rights or board representation if a certain number of dividends are missed. Others are convertible into common stock or debt under specific conditions.

From an issuer's perspective, preferred stock offers several advantages. It allows companies to lock in financing costs and potentially leverage returns to common shareholders without increasing default risk. Many preferred stock issues are sold privately to institutional investors, resulting in lower issuance costs and less stringent disclosure requirements. And preferred stock can help companies raise funds without altering their overall leverage ratio — a factor that is often viewed favorably by rating agencies.

For investors, particularly institutional ones, preferred stock can be an attractive option. It provides a more predictable income stream compared to common stock, and for most U.S. corporate holders, 50% of the dividend income may be excluded from federal income tax. However, the fixed nature of preferred dividends means that the stock's price can be sensitive to interest rate movements.

Preferred stock has found particular favor among certain types of companies. Financial institutions frequently issue preferred stock because it often counts towards regulatory capital requirements. For newly established or high-growth firms, as well as companies in financial distress, the tax advantages of debt financing are minimal, making the cost differential between debt and preferred stock relatively small. Thus, when considering the equity nature of preferred stock, this form of financing can be particularly appealing.

Debt market vs. equity market

Any discussion of stocks and bonds has to include the capital market. This is where savings and investments are funneled between suppliers — individuals or institutions with capital to invest or lend (e.g., banks, investors) — and those who need it (issuers), typically businesses, governments and individuals.

The capital market is subdivided into the debt market and the equity market. Investors purchase bonds in the debt market. Bonds represent a loan from an investor to the issuer, with fixed interest and principal payments. They do not provide an ownership stake, and a bond’s liquidity typically decreases as it gains maturity.

In the equity market, investors buy and trade stocks, which represent ownership in the issuing company. Stockholders may earn dividends or capital gains, and there is no maturity date attached to stocks.

Also important to stocks and bonds are the primary and secondary markets. New stocks and bonds are issued through the primary market, either through Initial Public Offerings (IPOs) or bond issuances. It is within this market that new capital is raised for issuers.

In the secondary market, investors trade existing stocks and bonds. The issuing firm is not involved, and there are no changes to the number of outstanding securities.

Debt securities (bonds) offer fixed payments and no ownership stake, while equity securities (stocks) provide ownership but come with higher risk and no guaranteed returns. Both are essential components of capital markets, serving different purposes for issuers and investors.

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