Stocks and Bonds Made Simple

When the government wants to raise money, they can issue bonds and borrow money from the people.  When corporations want to raise large amounts of capital (money), they can issue stocks or bonds.  If they issue bonds they borrow money from investors, like government entities do.  If they issue stocks they sell shares of ownership in their company, common stock.

In either case, once the bonds or stocks are sold to the public, the government or corporation gets its money and has an obligation to whoever owns the bonds or stocks it issued.  After this the stocks or bonds are securities that trade in the open market.  Stocks trade in the stock market and bonds trade in the bond market.  How simple can you get?

So, when you or I buy stocks or bonds, we are simply buying them in the market through a broker who charges us a commission for his services.  The government or corporation already got their money.  We are simply buying bonds or shares of stock a previous owner told his broker to sell.  When we want to sell we simply do it through our broker as well.  That’s why having a stock market and a bond market is so important.

Markets provide liquidity.  In other words, who would buy these stocks and bonds if they could not sell them at a fair price quickly and easily?

As investments, stocks and bonds are like night and day – heads and tails.  When you own stocks you have ownership in the company.  If the company prospers and the stock market is on a roll, you benefit as the price or value of your stock shares go up.  If the company pays dividends, you get your fair share based on the number of shares you own.  All common stock shares are equal.  Some folks just own more shares than others.

On the other hand, if the company goes broke you lose big.  As a shareholder and an owner, you can end up with nothing after the creditors (including bondholders) get what’s due them.  You will know you are in trouble when your stock approaches zero and quits trading in the stock market.  The only good news in this case is that you can only lose what you invested.  Second, you may have a tax write-off  for your losses.

Bonds are of a different breed.  When you own bonds the issuer owes you money, and pays you interest.  If the company or government entity (like the U.S. government or the state of Ohio) gets into financial trouble and defaults on interest payments or principal, you are a creditor with certain rights.  For example, you get yours before stockholders get theirs.  Thus, bonds are safer than stocks, but they lack the profit potential of the former.

Every bond has a limited life, unlike stocks that live indefinitely.  When a bond matures, the owner (whoever it is) is paid back the principal, usually $1000 for most bonds.  Now pay attention.  Bonds are safer than stocks.  But this does not mean that they are necessarily safe.  The main advantage of owning bonds over really safe investments like savings accounts, CD’s and Savings Bonds (which are savings vehicles and not really bonds) is that they pay higher interest rates.  But, unlike the safer investments just mentioned, bonds trade in the bond market … and anything that trades in any market experiences price changes as it trades.

In other words, the price or value of bonds fluctuates.  That means that they go up and down in value like stocks do.  If you hold onto a typical bond until it matures, you should get $1000, no matter what you paid for it.  On the other hand, if you sell it before maturity, you will get more or less, depending on the market price of your bond at the time.