Fall 2009 » UA Q & A » What is the difference between a stock and a bond?

What is the difference between a stock and a bond?

February, 2008

Craig G. Rennie, Clete and Tammy Brewer Professor of Financial Markets in the Sam M. Walton College of Business and managing director of the Garrison Financial Institute replies:

Stocks and bonds are two different financial securities. Stocks represent equity ownership in corporations, either as common or preferred stock. Common stock gives shareholders ownership claims against the residual cash flows of the firm - i.e., what remains after creditors and preferred shareholders are paid. Preferred shareholders have claims against cash flows after creditors are paid, typically in the form of fixed dividends. Common shareholders expect higher returns over longer periods than preferred shareholders because they bear more risk. Dividends are usually paid quarterly, if at all in the case of common stock, are not tax deductible by the issuer (unlike interest), and, together with capital gains, currently receive preferential income tax treatment in the hands of recipients.  As owners of corporations, shareholders vote.

Bonds represent debt. Bond holders receive fixed coupon payments (typically twice a year) and principal on maturity. Bond holders have a higher claim on the cash flows of a corporation, meaning bond holders get paid before stockholders in the event of bankruptcy. Bonds are issued by governments as well as corporations, and are valued using present value formulas with spot interest rates, sometimes with complex calculations to account for default or liquidity risk and other features.  Government issued bond investors sometimes also receive preferential tax treatment. In short, stocks and bonds are two distinct forms of financial securities that possess different cash flow features, voting rights and priority and maturity characteristics. When combined, they can form part of a well diversified investment portfolio.