Hello everyone! When you start investing and looking to invest in a basic fund with a company like Vanguard or Hargreaves Landsdown, you may find yourself presented with a selection of portfolio that are geared to differing degrees between bonds (also known as fixed income) and equities.
To a new investor this can stump you a little bit – what should I choose, and what are the differences between them?
I’m going to run through a very general sense to start us off with what each option would mean for you as an investor. We’ll then also run through some of the more technical differences in what the two products actually are.
As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter need to be right for your circumstances. We always suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.
The key difference between Bonds and Equity as an investor
If you want the very quick version of this article, the key difference most people will care about is that bonds and equities generally have different risk and return metrics.
Most investment-grade bonds will give you a lower return, but also lower risk – you have more certainty of what you’ll get back as a rate of return. Unless a company goes bankrupt and defaults on it’s bonds, you won’t make a loss. A bond will also be for a fixed timeframe of investment.
Most equities will provide a high return, but also higher risk – share prices can be volatile and the returns you get from them are much less certain. Even if a company doesn’t go bankrupt, the share price can go down and you can make a loss on the investment. An equity is also simply bought for no fixed timeframe.
Important caveat: If a bond purports to offer a high rate of return (more than a couple of %) then the bond is in something with a high chance of default – more on this below. Many borderline-scams reference guaranteed returns with bonds alongside high return figures, and if you see “guaranteed return” and something that seems like a high return together on something referenced as a bond it should ring some alarm bells.
Variants on bonds like “mini-bonds” can also introduce more risk to the investor. For avoidance of doubt, when we refer to bonds in this article, we mean standard bonds only. If you’re investing with a mainstream investment platform, that should be what they mean as well.
How can I assess what weighting of Bonds and Equity is right for me?
Broadly speaking based on the above, weighting more towards equity exposes you to more risk and more return, and as you weight towards bonds the opposite.
This question cannot be answered easily in general terms though – because how much risk/return very much depends exactly what bonds or equities are being invested in.
However there is a way you can at least part assess by looking at the investment information documents, which are a required disclosure for an investment fund. These should tell you the historic rates of return that the fund has seen. You don’t just want to look at the good years, but also at years the fund made a loss – how bad did it get?
This should help give you some idea of both the upside and the downside you would potentially be looking at with the investment.
The flaw of course is that some funds aren’t that old – so you may not have an extensive history to map out (or given the past couple of years have been pretty good for the market, you may not have enough history to be able to judge what a truly bad period looks like).
What is an Equity investment?
If you buy equity, also known as a share, you are literally purchasing a portion of ownership in the underlying company.
In terms of why we’d make this investment, we hope for two things from this:
- As the value of the overall company in the market changes, your share will gain or lose in price. This can be substantial over tie.
- Where the company doesn’t reinvest money into the company, they will usually seek to distribute those profits to the shareholders in the form of a dividends – a payment you receive instantly.
There’s a couple of other benefits. Owning equity also secures you an invitation to the companies Annual General Meeting (AGM), which provides the opportunity to hear from and potentially speak to executives at the firm.
It may also secure you voting on key issues of shareholder Governance, albeit the weight of your vote will be limited to how many shares you own. (Slight caveat: This is usually the case – there are some companies that modify their stock so it does not provide this right, but this is the exception not the norm).
The plus side of equity is the gains that can be made from being a part-owner if the company does well can be really significant. The downside is that if the company goes bust, you are usually last in the queue when it comes to any potential recoveries from the remains of the company, as repaying bondholders is near-always a higher priority.
What is a Bond or Fixed Income Investment?
If you are buying a bond, you’re actually purchasing the company’s debt.
Let’s break this down more simply:
A company wants to borrow a set amount of money from you for a fixed period to fund their growth. In exchange for this, they promise to pay you back the full amount at the end of the agreed period plus interest as compensation, and may also agree to pay you back small amounts throughout the life of the bond.
(It’s not quite the same, but I find thinking of this in a similar way to you being a bank issuing a mortgage to be conceptually helpful in thinking about this).
The rate of interest paid out will depend on how secure the company is, which is determined by financial analysis performed by a credit ratings agency. If a company is more likely to go bankrupt, the company will need to offer you a higher rate of interest on the bond to compensate you for the risk.
Agencies use slightly different classifications but earlier letter in the alphabet or smaller numbers signify better quality – so an AAA bond is as solid as you can get, and a CCC bond has some serious risk of default.
I’ve included a handy table here which goes through the different classifications and what they mean:
So we have two beneficial flows from our investment:
- We know what we’re getting back at the end of the agreed period – what we put in initially (known as the principal) plus a rate of interest.
- We may get small payment over the life of the bond, known as coupons.
We don’t have any ownership rights with the company so unless it goes bust and can’t repay our principal at the end of the life of the bond, the financial performance of the company won’t make a difference to the return.
However if the company does go bust, you’re usually higher in the queue when it comes to getting any money back from what value exists in the company’s assets (although expect this to be significantly lower than your initial investment).
If you’ve got any further questions on the differences between bonds and equities (or think we’ve missed a useful key difference) then leave us a comment below!